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Chapter 17 ECONOMIC POLICY Learning Outcomes 17.1 Compare and contrast three theories of market economics: laissez-faire, Keynesian, and supply-side. 17.2 Describe the process by which the national budget is prepared and passed into law and the reforms undertaken by Congress to balance the budget. 17.3 Identify the objectives of tax policies and explain why tax reform is difficult. Copyright 2014 Cengage Learning 2 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. 17.5 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. Copyright 2014 Cengage Learning 3 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 Copyright 2014 Cengage Learning 4 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 Copyright 2014 Cengage Learning 5 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) Copyright 2014 Cengage Learning 6 Dueling Economists on YouTube Copyright 2014 Cengage Learning 7 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 Copyright 2014 Cengage Learning 8 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 Copyright 2014 Cengage Learning 9 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 Copyright 2014 Cengage Learning 10 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 Copyright 2014 Cengage Learning 11 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 Copyright 2014 Cengage Learning 12 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 Copyright 2014 Cengage Learning 13 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 Copyright 2014 Cengage Learning 14 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 Copyright 2014 Cengage Learning 15 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 Copyright 2014 Cengage Learning 16 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) Copyright 2014 Cengage Learning 17 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 Copyright 2014 Cengage Learning 18 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 Copyright 2014 Cengage Learning 19 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 Copyright 2014 Cengage Learning 20 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 Copyright 2014 Cengage Learning 21 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 Copyright 2014 Cengage Learning 22 Copyright 2014 Cengage Learning 23 Copyright 2014 Cengage Learning 24 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” Copyright 2014 Cengage Learning 25 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 Copyright 2014 Cengage Learning 26 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 Copyright 2014 Cengage Learning 27 Copyright 2014 Cengage Learning 28 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 Copyright 2014 Cengage Learning 29 FIGURE 17.5 Distribution of Family Income over Time Copyright 2014 Cengage Learning 30 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 Copyright 2014 Cengage Learning 31 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 Copyright 2014 Cengage Learning 32