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8.5: Budgeting and Tax Policy

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    A country spends, raises, and regulates money in accordance with its values. The federal government’s budget for 2022 was $6.011 trillion. The role of politics in drafting the annual budget is indeed large. In addition, policymakers make considerable effort to ensure that long-term priorities are protected from the heat of the election cycle and short-term changes in public opinion. The decision to put some policymaking functions out of the reach of Congress also reflects economic philosophies about the best ways to grow, stimulate, and maintain the economy.

    Approaches to the Economy

    Until the 1930s, most policy advocates argued that the best way for the government to interact with the economy was through a hands-off approach formally known as laissez-faire economics. Proponents thought private investors were better equipped than governments to figure out which sectors of the economy were most likely to grow and which new products were most likely to be successful. They also tended to oppose government efforts to establish quality controls or health and safety standards, believing consumers themselves would punish bad behavior by not trading with poor corporate citizens. Finally, laissez-faire proponents felt that keeping government out of the business of business would create an automatic cycle of economic growth and contraction. (Contraction phases in which there is no economic growth for two consecutive quarters, called recessions, brings business failures and higher unemployment.)

    The Great Depression challenged the laissez-faire view. When President Franklin Roosevelt came to office in 1933, the United States had already been in the depths of the Great Depression for several years, since the stock market crash of 1929. Roosevelt sought to implement a new approach to economic regulation known as Keynesianism. Developed by economist John Maynard Keynes, Keynesian economics argues that it is possible for a recession to become so deep, and last for so long, that the typical models of economic collapse and recovery may not work. Keynes suggested that economic growth was closely tied to the ability of individuals to consume goods. It didn’t matter how or where investors wanted to invest their money if no one could afford to buy the products they wanted to make. And in periods of extremely high unemployment, wages for newly hired labor would be so low that new workers would be unable to afford the products they produced.

    Keynesianism counters this problem by increasing government spending in ways that improve consumption. Some of the proposals Keynes suggested were payments or pension for the unemployed and retired, as well as tax incentives to encourage consumption in the middle class. His reasoning was that these individuals would be most likely to spend the money they received by purchasing more goods, which in turn would encourage production and investment. Keynes argued that the wealthy class of producers and employers had sufficient capital to meet the increased demand of consumers that government incentives would stimulate. Once consumption had increased and capital was flowing again, the government would reduce or eliminate its economic stimulus, and any money it had borrowed to create it could be repaid from higher tax revenues.

    Keynesianism dominated U.S. fiscal or spending policy for roughly 40 years. By the 1970s, however, high inflation began to slow economic growth primarily due to higher oil prices and the costs of fighting the Vietnam War. However, some economists, such as Arthur Laffer, began to argue that the social welfare and high tax policies created in the name of Keynesianism were overstimulating the economy, creating a situation in which demand for products had outstripped investors’ willingness to increase production.[1] This new approach was titled supply-side economics. Supply-siders have argued that increased regulation and higher taxes reduce the incentive to invest new money into the economy, to the point where little growth can occur. In addition, they have advocated reducing taxes and regulations to spur economic growth.

    Mandatory Spending vs. Discretionary Spending

    The Keynesian goal to create a minimal level of aggregate demand, coupled with a Depression-era preference to promote social welfare policy, led the president and Congress to develop a federal budget with two broad spending categories: mandatory and discretionary.

    • Mandatory spending is the larger category. In 2022, Mandatory spending is estimated to be $4.018 trillion, and includes entitlement programs such as Social Security, Medicare, and unemployment compensation. It also includes welfare programs such as Medicaid. Keynesians support mandatory spending, along with other elements of social welfare policy, because they help maintain a minimal level of consumption that should, in theory, prevent recessions from turning into depressions, which are more severe downturns.
    • Discretionary spending is the funds allocated by Congress to cover the administrative expenses of executive branch agencies, congressional offices and agencies, and international operations of the government.It also covers science and technology spending, foreign affairs initiatives, education spending, federally provided transportation costs, and many of the redistributive benefits most people in the United States have come to take for granted. Defense spending is also a part of this category.
    2020-us-government-spending-chart.jpg.jpg
    Figure 2. This graphic of the U.S. Government Spending 2020 was developed by the Congressional Budget Office.

    Balancing the budget has been a major goal of both the Republican and Democratic parties for the past several decades, although the parties tend to disagree on the best way to accomplish the task. One frequently offered solution, particularly among supply-side advocates, is to simply cut spending. This has proven to be much easier said than done. If Congress were to try to balance the budget only through discretionary spending, it would need to cut about one-third of spending on programs like defense, higher education, agriculture, police enforcement, transportation, and general government operations. Given the number and popularity of many of these programs, it is difficult to imagine this would be possible. To use spending cuts alone as a way to control the deficit, Congress will almost certainly be required to cut or control the costs of mandatory spending programs like Social Security and Medicare—a radically unpopular step.

    Tax Policy

    Balancing the budget might be possible through increase revenue. The most common way is by applying some sort of tax on residents (or on their behaviors) in exchange for the benefits the government provides. Taxation comes with potential downfalls. First, the more money the government collects to cover its costs, the less residents are left with to spend and invest. Second, attempts to raise revenues through taxation may alter the behavior of residents in ways that are counterproductive to the state and the broader economy. Excessively taxing necessary and desirable behaviors like consumption (with a sales tax) or investment (with a capital gains tax) will discourage citizens from engaging in them, potentially slowing economic growth. The goal of tax policy is to determine the most effective way of meeting the nation’s revenue obligations without harming other public policy goals.

    An image of a person’s hand, holding a pen over a form.
    Figure 4. A U.S. marine fills out an income tax form. Income taxes in the United States are progressive taxes.

    Two prominent tax systems have been suggested and/or implemented:

    • Keynesians prefer progressive taxes systems that increase the effective tax rate as the taxpayer’s income increases. This policy leaves those most likely to spend their money with more money to spend. For example, in 2015, U.S. taxpayers paid a 10 percent tax rate on the first $18,450 of income, but 15 percent on the next $56,450 (some income is excluded).[5] The rate continues to rise, to up to 39.6 percent on any taxable income over $464,850. The top income earners pay a greater portion of the overall income tax burden than do those at the lowest tax brackets.
    • Supply-siders prefer regressive tax systems, which lower the overall rate as individuals make more money. This action does not automatically mean the wealthy pay less than the poor, rather the percentage of their income they pay in taxes will be lower. The use of excise taxes or 'sin taxes' on specific goods or services such as alcohol, tobacco, and gasoline have a regressive quality, since the amount of the good purchased by the consumer, and thus the tax paid, does not increase at the same rate as income. The payroll tax that funds Social Security is another example. In 2015, only people making less than $118,500 were taxed at 7.65% for Social Security. Then, the overall tax rate fell as their income increased.
    2020_US_Federal_Budget_Infographic.png
    Figure 6. This image show the Outlays and the Revenue for 2020.

    The Federal Reserve Board and Interest Rates

    The 1913 Federal Reserve Act created the Federal Reserve System, known simply as "The Fed." It was implemented to establish economic stability in the U.S. by introducing a central bank to oversee monetary policy. The Fed’s three original goals to promote were maximum employment, stable prices, and moderate long-term interest rates. All of these goals bring stability. Today, the Fed influenced monetary policy (the means by which the nation controls the size and growth of the money supply), supervises and regulates banks, and provides them with financial services like loans.

    The Federal Reserve System is overseen by a board of governors, known as the Federal Reserve Board. The U.S. president appoints seven governors, each of whom serves a fourteen-year term (the terms are staggered). A chair and vice-chair lead the board for terms of four years each. The most important work of the board is participating in the Federal Open Market Committee to set monetary policy, like interest rate levels and macroeconomic policy. It also oversees a network of twelve regional Federal Reserve Banks, each of which serves as a “banker’s bank” for the country’s financial institutions.

    The Role of the Federal Reserve Chair

    If you have read or watched the news for the past several years, perhaps you have heard the names Janet Yellen, Ben Bernanke, or Alan Greenspan. These people have all served as the board of governors of the Federal Reserve System By raising or lowering banks’ interest rates, the chair has the ability to reduce inflation or stimulate growth. The Fed’s dual mandate is to keep inflation low (under 2 percent) and unemployment low (below 5 percent), but efforts to meet these goals can often lead to contradictory monetary policies.

    Image A is of Alan Greenspan. Image B is of Janet Yellen.
    Figure 8. Economist Alan Greenspan (a) was chair of the board of governors of the Federal Reserve System from 1987 to 2006, the second-longest tenure of any chair. Janet Yellen (b) succeeded Ben Bernanke as chair in 2014, after serving as vice chair for four years. Prior to serving on the Federal Reserve Board, Yellen was president and CEO of the Federal Reserve Bank of San Francisco. She was succeeded by Jerome Powell in February 2018.

    Many of the economic events of the past five decades, both good and bad, are the results of Fed policies. In the 1970s, double-digit inflation brought the economy almost to a halt. When Paul Volcker became chair in 1979, he raised interest rates and jump-started the economy. After the stock market crash of 1987, then-chair Alan Greenspan declared, “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to…support the economic and financial system.”[2] His lowering of interest rates led to an unprecedented decade of economic growth through the 1990s. In the 2000s, consistently low interest rates and readily available credit contributed to the sub-prime mortgage boom and subsequent bust, which led to a global economic recession beginning in 2008.

    Resources

    1. "2015 Federal Tax Rates, Personal Exemptions, and Standard Deductions," http://www.irs.com/articles/2015-federal-tax-rates-personal-exemptions-and-standard-deductions (March 1, 2016).
    2. https://www.federalreserveeducation.org/about-the-fed/history (March 1, 2016).
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