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Funding Government Programs
• Citizens of the United States authorize the government,
through the Constitution and elected officials, to raise
money through taxes.
• Taxation is the primary way that the government
collects money.
• Without revenue, or income from taxes, government
would not be able to provide goods and services.
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Taxes and the Constitution
The Power to Tax
Limits on the Power to Tax
• Article 1, Section 8, Clause 1
of the Constitution grants
Congress the power to tax.
The power to tax is also limited
through the Constitution:
• The Sixteenth Amendment
gives Congress the power to
levy an income tax.
1. The purpose of the tax must
be for “the common defense
and general welfare.”
2. Federal taxes must be the
same in every state.
3. The government may not tax
exports.
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Tax Bases and Tax Structures
A tax base is the income, property, good,
or service that is subject to a tax.
•
Proportional Taxes
– A proportional tax is a tax for which the percentage of income paid in
taxes remains the same for all income levels.
•
Progressive Taxes
– A progressive tax is a tax for which the percent of income paid in
taxes increases as income increases.
•
Regressive Taxes
– A regressive tax is a tax for which the percentage of income paid in
taxes decreases as income increases.
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Characteristics of a Good Tax
• A good tax has the following characteristics:
– Simplicity
• Tax laws should be simple and easily understood.
– Economy
• Government administrators should be able to collect taxes
without spending too much time or money.
– Certainty
• It should be clear to the taxpayer when the tax is due, how
much is due, and how it should be paid.
– Equity
• The tax system should be fair, so that no one bears too
much or too little of the tax burden.
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Individual Income Taxes
• “Pay-as-You-Earn” Taxation
– Federal income taxes are collected throughout the
course of the year as individuals earn income.
• Tax Withholding
– Withholding is the process by which employers take
tax payments out of an employee’s pay before he or
she receives it.
• Tax Brackets
– The federal income tax is a progressive tax. In 1998,
there were five rates, each of which applied to a
different range of income.
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Filing a Tax Return
•
A tax return is a form on which you declare your income to the
government and determine your taxable income.
•
Taxable income is a person’s total (or gross) income minus exemptions
and deductions.
Exemptions are set
amounts that you
subtract from your
gross income for
yourself, your
spouse, and any
dependents.
HOURS AND EARNINGS
Hours
Earnings
20
200.00
TAXES AND DEDUCTIONS
Description
Amount
FICA
15.20
Federal
10.25
State
5.10
City
1.00
Total Taxes
31.55
TOTAL
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Taxable Wages
Less Taxes
Net Pay
200.00
31.55
168.45
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Deductions are
variable amounts that
you can subtract
from your gross
income.
Corporate Income Taxes
• Like an individual, a corporation must pay a federal tax
on its taxable income.
• Corporate income taxes are progressive — as a
company’s profits increase so does the amount paid in
taxes.
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Social Security, Medicare,
and Unemployment Taxes
•
Social Security Taxes
– This program is funded by the Federal Insurance Contributions Act
(FICA). Most of the FICA taxes you pay go to Social Security, or OldAge, Survivors, and Disability Insurance (OASDI)
•
Medicare Taxes
– Medicare is a national health insurance program that helps pay for
health care for people over 65 and for people with certain disabilities.
Medicare is also funded by FICA taxes.
•
Unemployment Taxes
– Unemployment taxes are collected by both federal and state
governments. Workers can collect “unemployment compensation” if
they are laid off through no fault of their own and if they are actively
looking for work.
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Other Types of Taxes
•
Excise Taxes
– An excise tax is a tax on the sale or production of a good. Federal
excise taxes range from gasoline to telephone services.
•
Estate Taxes
– An estate tax is a tax on the estate, or total value of the money and
property, of a person who has died. Estate taxes are paid before
inheritors receive their share.
•
Gift Taxes
– A gift tax is a tax on the money or property that one living person
gives to another.
•
Import Taxes
– Taxes on imported goods are called tariffs.
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Mandatory and Discretionary Spending
Spending Categories
• Mandatory spending refers to
money that lawmakers are
required by law to spend on
certain programs or to use for
interest payments on the
national debt.
• Discretionary spending is
spending about which
government planners can
make choices.
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Entitlements
An entitlement program is a social welfare program that
people are “entitled” to if they meet certain eligibility
requirements.
•
Social Security
– Social Security is the largest category of government spending.
•
Medicare
– Medicare pays for certain health benefits for people over 65 or people
who have certain disabilities and diseases.
•
Medicaid
– Medicaid benefits low-income families, some people with disabilities,
and elderly people in nursing homes. Medicaid costs are shared by
the federal and state governments.
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Discretionary Spending
Defense Spending
Other Discretionary Spending
• Spending on defense
accounts for about half of the
federal government’s
discretionary spending.
• Other discretionary spending
categories include:
• Defense spending pays
military personnel salaries,
buys military equipment, and
covers operating costs of
military bases.
– Education
– Training
– Environmental cleanup
– National parks and
monuments
– Scientific research
– Land management
– Farm subsidies
– Foreign aid
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State Budgets
• Operating Budgets
– A state’s operating budget pays for day-to-day
expenses. These include salaries, supplies, and
maintenance of state facilities.
• Capital Budgets
– A state’s capital budget pays for major capital, or
investment, spending.
• Balanced budgets
– Some states have laws requiring balanced budgets.
These laws, however, only apply to a state’s operating
budget.
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Where Are State Taxes Spent?
•
•
•
•
•
•
Education
– State education budgets help finance public state universities and provide
some aid to local governments for elementary, middle, and high schools.
Public Safety
– State governments operate state police systems, as well as correctional
facilities within a state.
Highways and Transportation
– Building and maintaining highways is another state expense. States also pay
some of the costs of waterways and airports.
Public Welfare
– State funds support some public hospitals and clinics. States also help pay for
and administer federal benefits programs.
Arts and Recreation
– State parks and some museums and historical sites are funded by state
revenues.
Administration
– Like the federal government, state governments spend money just to keep
running.
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State Tax Revenues
• Limits to State Taxation
– Because trade and commerce are considered national
enterprises, states cannot tax imports or exports. They also
cannot tax goods sent between states.
• Sales Taxes
– Sales taxes are the main source of revenue for many states.
• Other State Taxes
– Different states have various other means to collect revenue,
such as state income taxes, excise taxes, corporate income
taxes, business taxes, and property taxes.
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Local Government Spending and
Revenues
The Jobs of Local Government
Local Government Revenues
•
•
Property taxes are the main
source of local revenue. These
taxes are paid by people who own
homes, apartments, buildings, or
land.
•
Local governments sometimes
collect excise, sales, and income
taxes as well.
•
Some taxes, such as room and
occupancy taxes, are aimed at
nonresidents in order for local
governments to earn additional
revenue.
The following is a brief list of the
many functions that local
governments carry out or assist
in:
– Public school systems
– Law enforcement
– Fire protection
– Public transportation
– Public facilities, such as
libraries and hospitals
– Parks and recreational
facilities
– Record keeping (birth/death
certificates, wills, etc.)
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What Is Fiscal Policy?
• The tremendous flow of cash into and out of the
economy due to government spending and taxing has a
large impact on the economy.
• Fiscal policy decisions, such as how much to spend
and how much to tax, are among the most important
decisions the federal government makes.
Fiscal policy is the federal government’s use of
taxing and spending to keep the economy stable.
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Fiscal Policy and the Federal Budget
• The federal budget is a written
document indicating the
amount of money the
government expects to
receive for a certain year and
authorizing the amount the
government can spend that
year.
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• The federal government
prepares a new budget for
each fiscal year. A fiscal year
is a twelve-month period that
is not necessarily the same as
the January – December
calendar year.
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The Budget Process
• Congress and the White
House work together to
develop a federal budget.
Creating the Federal Budget
Federal agencies send requests for money to
the Office of Management and Budget.
The Office of Management and Budget works
with the President to create a budget. In
January or February, the President sends this
budget to Congress.
Congress makes changes to the budget and
sends this new budget to the President.
The President signs the
budget into law.
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The President vetoes the
budget. If Congress cannot
get a 2⁄3 majority to override
the President’s veto,
Congress and the President
must work together to create
a new, compromise, budget.
Fiscal Policy and the Economy
The total level of government spending can be
changed to help increase or decrease the output
of the economy.
Expansionary Policies
Contractionary Policies
• Fiscal policies that try to
increase output are known as
expansionary policies.
• Fiscal policies intended to
decrease output are called
contractionary policies.
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Expansionary Fiscal Policies
Increasing Government Spending
If the federal government
increases its spending or
buys more goods and
services, it triggers a chain of
events that raise output and
creates jobs.
Cutting Taxes
•
When the government cuts
taxes, consumers and
businesses have more money
to spend or invest. This
increases demand and output.
Effects of Expansionary Fiscal Policy
High
prices
Aggregate
supply
Higher output,
higher prices
Price level
•
Aggregate
demand
with higher
government
spending
Lower output,
lower prices
Original
aggregate
demand
Low
prices
Low output
High output
Total output in the economy
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Contractionary Fiscal Policies
Decreasing Government Spending
If the federal government spends
less, or buys fewer goods and
services, it triggers a chain of
events that may lead to slower
GDP growth.
Raising Taxes
•
If the federal government
increases taxes, consumers and
businesses have fewer dollars to
spend or save. This also slows
growth of GDP.
Effects of Contractionary Fiscal Policy
High
prices
Aggregate
supply
Higher output,
higher prices
Price level
•
Lower output,
lower prices
Original
aggregate
demand
Aggregate
demand with lower
government
spending
Low
prices
Low output
High output
Total output in the economy
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Limits of Fiscal Policy
Difficulty of Changing Spending Levels
– In general, significant changes in federal spending must come from
the small part of the federal budget that includes discretionary
spending.
Predicting the Future
– Understanding the current state of the economy and predicting future
economic performance is very difficult, and economists often
disagree. This lack of agreement makes it difficult for lawmakers to
know when or if to enact changes in fiscal policy.
Delayed Results
– Even when fiscal policy changes are enacted, it takes time for the
changes to take effect.
Political Pressures
– Pressures from the voters can hinder fiscal policy decisions, such as
decisions to cut spending or raising taxes.
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Coordinating Fiscal Policy
• For fiscal policies to be effective, various branches and
levels of government must plan and work together,
which is sometimes difficult.
• Federal policies need to take into account regional and
state economic differences.
• Federal fiscal policy also needs to be coordinated with
the monetary policies of the Federal Reserve.
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Classical Economics
• The idea that markets regulate themselves is at the
heart of a school of thought known as classical
economics.
• Adam Smith, David Ricardo, and Thomas Malthus are
all considered classical economists.
• The Great Depression that began in 1929 challenged
the ideas of classical economics.
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Keynesian Economics
• Keynesian economics is the idea that the economy is
composed of three sectors — individuals, businesses,
and government — and that government actions can
make up for changes in the other two.
• Keynesian economists argue that fiscal policy can be
used to fight both recession or depression and
inflation.
• Keynes believed that the government could increase
spending during a recession to counteract the
decrease in consumer spending.
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The Multiplier Effect
• For example, if the federal government increases
spending by $10 billion, there will be an initial increase
in GDP of $10 billion. The businesses that sold the $10
billion in goods and services to the government will
spend part of their earnings, and so on.
• When all of the rounds of spending are added up, the
government spending leads to an increase of $50
billion in GDP.
The multiplier effect in fiscal policy is the idea that
every dollar change in fiscal policy creates a greater
than one dollar change in economic activity.
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Automatic Stabilizers
• A stable economy is one in
which there are no rapid
changes in economic factors.
Certain fiscal policy tools can
be used to help ensure a
stable economy.
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• An automatic stabilizer is a
government tax or spending
category that changes
automatically in response to
changes in GDP or income.
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Supply-Side Economics
• The Laffer curve shows how
both high and low tax
revenues can produce the
same tax revenues.
Laffer Curve
High
revenues
Tax revenues
• Supply-side economics
stresses the influence of
taxation on the economy.
Supply-siders believe that
taxes have a strong, negative
influence on output.
Low
revenues
b
a
0%
Low taxes
c
50%
Tax rate
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100%
High taxes
Balancing the Budget
Budget Surpluses
• A budget surplus occurs when revenues exceed
expenditures.
Budget Deficits
• A budget deficit occurs when expenditures exceed
revenue.
A balanced budget is a budget in which revenues
are equal to spending.
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Responding to Budget Deficits
Creating Money
Borrowing Money
• The government can pay for
budget deficits by creating
money. Creating money,
however, increases demand
for goods and services and
can lead to inflation.
• The government can also pay
for budget deficits by
borrowing money.
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• The government borrows
money by selling bonds, such
as United States Savings
Bonds, Treasury bonds,
Treasury bills, or Treasury
notes. The government then
pays the bondholders back at
a later date.
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The National Debt
The Difference Between Deficit and Debt
•
The deficit is amount the government owes for one fiscal year. The
national debt is the total amount that the government owes.
Measuring the National Debt
•
In dollar terms, the debt is extremely large: $5 trillion at the end of the
twentieth century. Economists often measure the debt as a percent of
GDP.
The national debt is the total amount of money the
federal government owes. The national debt is owed
to anyone who holds U.S. Savings Bonds or Treasury
bills, bonds, or notes.
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Is the Debt a Problem?
Problems of a National Debt
•
To cover deficit spending the government sells bonds. Every dollar spent
on a government bond is one fewer dollar that is available for businesses
to borrow and invest. This encroachment on investment in the private
sector is known as the crowding-out effect.
•
The larger the national debt, the more interest the government owes to
bondholders. Dollars spent paying interest on the debt cannot be spent
on anything else, such as defense, education, or health care.
Other Views of a National Debt
•
Keynesian economists argue that if government borrowing and spending
help the economy achieve its full productive capacity, then the national
debt outweighs the costs.
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The Federal Reserve Act of 1913
The Federal Reserve Act of 1913
A Stronger Fed
• The Federal Reserve System,
often referred to as “the Fed,”
is a group of 12 regional,
independent banks.
• In 1935, Congress adjusted
the Federal Reserve structure
so that the system could
respond more effectively to
crises.
• Initially the Federal Reserve
System did not work well
because the actions of one
regional bank would
counteract the actions of
another.
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• Today’s Fed has more
centralized powers so that
regional banks can work
together while still
representing their own
concerns.
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Structure of the Federal Reserve
•
The Board of Governors
– The Federal Reserve System is overseen by the seven-member Board of
Governors of the Federal Reserve. Actions taken by the Federal Reserve are
called monetary policy.
•
Federal Reserve Districts
– The Federal Reserve System consists of 12 Federal Reserve Districts, with one
Federal Reserve Bank per district. The Federal Reserve Banks monitor and
report on economic activity in their districts.
•
Member Banks
– All nationally chartered banks are required to join the Fed. Member banks
contribute funds to join the system, and receive stock in and dividends from
the system in return. This ownership of the system by banks, not government,
gives the Fed a high degree of political independence.
•
The Federal Open Market Committee (FOMC)
– The FOMC, which consists of The Board of Governors and 5 of the 12 district
bank presidents, makes key decisions about interest rates and the growth of
the United States money supply.
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The Pyramid Structure
of the Federal Reserve
Federal Open Market Committee
12 District
Reserve Banks
Board of Governors
Structure of the Federal Reserve System
4,000 member banks
and 25,000 other
depository institutions
• About 40 percent of all
United States banks
belong to the Federal
Reserve. These
members hold about 75
percent of all bank
deposits in the United
States.
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Federal Reserve Functions
• How does the Federal Reserve serve the federal
government?
• How does the Federal Reserve serve banks?
• How does the Federal Reserve regulate the banking
system?
• What role does the Federal Reserve play in regulating
the nation’s money supply?
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Serving Government
•
Federal Government’s Banker
– The Fed maintains a checking account for the Treasury Department
and processes payments such as social security checks and IRS
refunds.
•
Government Securities Auctions
– The Fed serves as a financial agent for the Treasury Department and
other government agencies. The Fed sells, transfers, and redeems
government securities. Also, the Fed handles funds raised from
selling T-bills, T-notes, and Treasury bonds.
•
Issuing Currency
– The district Federal Reserve Banks are responsible for issuing paper
currency, while the Department of the Treasury issues coins.
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Serving Banks
•
Check Clearing
– Check clearing is the process by which banks record whose account
gives up money, and whose account receives money when a customer
writes a check.
•
Supervising Lending Practices
– To ensure stability in the banking system, the Fed monitors bank
reserves throughout the system. The Fed also protects consumers by
enforcing truth-in-lending laws.
•
Lender of Last Resort
– In case of economic emergency, commercial banks can borrow funds
from the Federal Reserve. The interest rate at which banks can
borrow money from the Fed is called the discount rate.
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The Journey of a Check
• After you write a check,
the recipient presents it
at his or her bank.
The Path of a Check
Check writer
Recipient
• The check is then sent
to a Federal Reserve
Bank.
• The reserve bank
collects the necessary
funds from your bank
and transfers them to
the recipient’s bank.
• Your processed check is
returned to you by your
bank.
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Check
writer’s bank
Federal
Reserve Bank
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Regulating the Banking System
The Fed generally coordinates all
banking regulatory activities.
Reserves
Bank Examinations
• Each financial institution that
holds deposits for its
customers must report daily
to the Fed about its reserves
and activities.
• The Federal Reserve
examines banks periodically
to ensure that each institution
is obeying laws and
regulations.
• The Fed uses these reserves
to control how much money is
in circulation at any one time.
• Examiners may also force
banks to sell risky
investments if their net worth,
or total assets minus total
liabilities, falls too low.
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Regulating the Money Supply
The Federal Reserve is best known for its role in regulating the money
supply. The Fed monitors the levels of M1 and M2 and compares these
measures of the money supply with the current demand for money.
Factors That Affect Demand for Money
Stabilizing the Economy
1. Cash needed on hand (Cash makes
transactions easier.)
•
2. Interest rates (Higher interest rates
lead to a decrease in demand for cash.)
The Fed monitors the supply of and
the demand for money in an effort to
keep inflation rates stable.
3. Price levels in the economy (As prices
rise, so does the demand for cash.)
4. General level of income (As income
rises, so does the demand for cash.)
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Money Creation
How Banks Create Money
•
Assume that you have deposited $1,000 dollars in your checking account.
The bank doesn’t keep all of your money, but rather lends out some of it
to businesses and other people.
•
The portion of your original $1,000 that the bank needs to keep on hand,
or not loan out, is called the required reserve ratio (RRR). The RRR is set
by the Fed.
•
As the bank lends a portion of your money to businesses and consumers,
they too may deposit some of it. Banks then continue to lend out portions
of that money, although you still have $1,000 in your checking account.
Hence, more money enters circulation.
Money creation is the process by which money
enters into circulation.
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The Money Creation Process
To determine how much money is actually created by a deposit, we use the money
multiplier formula. The money multiplier formula is calculated as 1/RRR.
Money Creation
You deposit $1,000
into your checking
account.
Your $1,000 deposit
minus $100 in reserves
is loaned to Elaine, who
gives it to Joshua.
Joshua’s $900 deposit
minus $90 in reserves is
loaned to another
customer.
$100 held in reserve
$900 available for loans
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At this point, the money
supply has increased by
$2,710.
$90 held in reserve
$810 available for loans
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Reserve Requirements
The Fed has three tools available to adjust the money supply of the nation.
The first tool is adjusting the required reserve ratio.
Reducing Reserve Requirements
Increasing Reserve Requirements
•
A reduction of the RRR would
free up reserves for banks,
allowing them to make more
loans.
•
Even a slight increase in the RRR
would require banks to hold more
money in reserve, shrinking the
money supply.
•
A RRR reduction would also
increase the money multiplier.
Both of these effects would lead
to a substantial increase in the
money supply.
•
This method is not used often
because it would cause too much
disruption in the banking system.
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Discount Rate
The discount rate is the interest rate that banks pay to borrow money
from the Fed.
Reducing the Discount Rate
Increasing the Discount Rate
•
•
If the Fed wants to discourage
banks from loaning out more of
their money, it may make it more
expensive to borrow money if
their reserves fall too low.
•
Increasing the discount rate
causes banks to lend out less
money, which leads to a decrease
in the money supply.
•
If the Fed wants to encourage
banks to loan out more of their
money, it may reduce the
discount rate, making it easier or
cheaper for banks to borrow
money if their reserves fall too
low.
Reducing the discount rate
causes banks to lend out more
money, which leads to an
increase in the money supply.
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Open Market Operations
The most important monetary tool is open market operations.
Open market operations are the buying and selling of government
securities to alter the money supply.
Bond Purchases
Bond Sales
•
•
When the Fed sells bonds, it
takes money out of the money
supply.
•
When bond dealers buy bonds
they write a check and give it to
the Fed. The Fed processes the
check, and the money is taken
out of circulation.
•
In order to increase the money
supply, the Federal Reserve Bank
of New York buys government
securities on the open market.
The bonds are purchased with
money drawn from Fed funds.
When this money is deposited in
the bank of the bond seller, the
money supply increases.
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How Monetary Policy Works
Monetarism is the belief that the money supply is the
most important factor in macroeconomic performance.
The Money Supply and Interest
Rates
•
The market for money is like any
other, and therefore the price for
money — the interest rate – is
high when the money supply is
low and is low when the money
supply is large.
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Interest Rates and Spending
•
If the Fed adopts an easy money
policy, it will increase the money
supply. This will lower interest
rates and increase spending.
This causes the economy to
expand.
•
If the Fed adopts a tight money
policy, it will decrease the money
supply. This will push interest
rates up and will decrease
spending.
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The Problem of Timing
Good Timing
• Properly timed economic policy
will minimize inflation at the peak
of the business cycle and the
effects of recessions in the
troughs.
Bad Timing
• If stabilization policy is not timed
properly, it can actually make the
business cycle worse.
Business cycle
Business cycle with
properly timed
stabilization policy
Business cycle with
poorly timed
stabilization policy
Real GDP
Real GDP
Business Cycles and Stabilization Policy
Business
cycle
Time
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Policy Lags
Policy lags are problems experienced in the timing of
macroeconomic policy. There are two types:
Inside Lags
Outside Lags
• An inside lag is a delay in
implementing monetary
policy.
• Outside lags are the time it
takes for monetary policy to
take affect once enacted.
• Inside lags are caused by the
time it actually takes to
identify a shift in the business
cycle.
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Anticipating the Business Cycle
The Federal Reserve must not only react to current trends, but
also must anticipate changes in the economy.
Monetary Policy and Inflation
•
•
Expansionary policies enacted at
the wrong time can push inflation
even higher.
If the current phase of the
business cycle is anticipated to
be short, policymakers may
choose to let the cycle fix itself. If
a recession is expected to last for
years, most economists will favor
a more active monetary policy.
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How Quickly Does the Economy
Self-Correct?
•
Economists disagree about how
quickly an economy can selfcorrect. Estimates range from
two to six years.
•
Since the economy may take
quite a long time to recover on its
own, there is time for
policymakers to guide the
economy back to stable levels of
output and prices.
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Fiscal and Monetary Policy Tools
The federal government and the Federal Reserve both have tools to
influence the nation’s economy.
Fiscal and Monetary Policy Tools
Fiscal policy tools
Expansionary
tools
Contractionary
tools
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1. increasing government
spending
2. cutting taxes
1. decreasing government
spending
2. raising taxes
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Monetary policy tools
1. open market operations:
bond purchases
2. decreasing the discount
rate
3. decreasing reserve
requirements
1. open market operations:
bond sales
2. increasing the discount
rate
3. increasing reserve
requirements