Theories of Economic Policy
Economic policy refers to the actions that governments take in order to influence the economy. This usually involves controlling interest rates, regulating businesses, income redistribution, and various other monetary controls. Due to the global connectedness of financial markets, such policies must consider events on the international stage. Global financial institutions, such as the International Monetary Fund and the World Bank, work with countries to foster monetary cooperation, financial stability, and sustainable economic growth. Under Article 1, Section 8 of the U.S. Constitution, the federal government and the states are given the concurrent powers to enact taxing and spending policies for the “general welfare” of the country. The Founding Fathers believed it critical to include this clause. Under the Articles of Confederation (the first written constitution of the U.S.) the central government had no authority to lay and collect taxes and was forced to rely on donations from individual states. This policy wreaked havoc on the fiscal system and brought the new nation to the brink of economic collapse. Over time, the courts have interpreted the tax and spend clause to be very broad; however, beliefs about how this power should be utilized has been intensely debated by U.S. policymakers for years. Differences of opinion on this issue are usually based on competing philosophies about how much government should be involved in regulating the economy. The onset of the 2008 financial crisis, subsequent recession, and stubbornly high unemployment rates have only served to intensify the ongoing debate over U.S. economic policy.
To maintain a strong economy, the federal government must strive to achieve three broad economic goals: (1) stable prices; (2) full employment; and (3) economic growth. But economic policy activities do not end there. The federal government seeks to maintain sound economic health through a variety of other objectives. These include maintaining low or stable interest rates, striving for a balanced budget (or at least a budget that strives to reduce the deficit from the previous year), and a positive trade balance with other countries (meaning more exports than imports).
When prices for goods and services increase sharply (known as inflation), the value of money is reduced, and it costs more to buy the same things. When inflation rates are kept low, prices remain at the same level. But a variety of circumstances beyond the government's control can affect prices. A prolonged drought in the corn belt or an early freeze that hits the orange crop in Florida creates shortages that lead to higher prices. Higher prices for certain critical goods, such as oil, can create inflationary prices throughout the economy.
Video: Inflation Explained Part 1
Absolute full employment is impossible to achieve; at any given time, people are quitting their jobs or are unable to work for a variety of reasons. An unemployment rate, the percentage of the labor force that is out of work, of 4 percent or less is considered full employment. The unemployment rate varies from region to region and from state to state. For example, California's rate was higher than the national average in the early 1990s because of cutbacks in the aerospace industry and companies moving out of the state.
Video: Unemployment and Employment
Economic growth is measured by the gross domestic product (GDP), the dollar value of the total output of goods and services in the United States. A thriving economy may have a GDP growth rate of four percent a year; a stagnant economy may grow at less than one percent a year. In a stagnant economy, unemployment is high, productivity is low, and jobs are hard to find. A recession is defined as two consecutive quarters of negative GDP. In the 1970s, the United States experienced a strange combination of high unemployment and high inflation, which is known as stagflation.
Video: GDP Explained
Sources of Revenue and Expenditures
Federal economic policy relies on the use of taxing and spending to provide for government services but taxing and spending decisions also affect the stability of the U.S. economic system, the value of currency, and the decisions of business owners and consumers which lead to either economic growth or decline. Therefore, it is important to understand where governmental revenues come from and how the government spends those revenues.
The primary source of revenue for the federal government is through federal income taxes to individuals and corporations as well as taxes on the payrolls of business operations in order to fund social security and federal unemployment and disability benefits. The United States uses a graduated progressive tax system, which increases the percentage of income paid in taxes in relation to the total income an individual makes each year. In other words, the more money an individual makes, the more money (in theory) that individual will pay in income taxes.
The chart below demonstrates the progressive nature of the federal income tax system. As income rises, so does the percentage of income one must pay in federal income taxes until it reaches a maximum rate of 39 percent. But other countries such as Sweden have tax rates between 79 percent and 90 percent of income at higher tax brackets.
Look at the table provided below. Individual income taxes and payroll taxes accounted for 82 percent of all federal revenues in the fiscal year 2010. Corporate income taxes contributed another nine percent. Excise taxes, estate and gift taxes, customs duties, and miscellaneous receipts (earnings of the Federal Reserve System and various fees and charges) made up the balance. The composition of tax revenue has changed markedly over the past half century. The share coming from individual income taxes has remained roughly constant, while payroll taxes have accounted for a larger share and corporate income and excise taxes smaller shares.
In 2010 the federal government collected $2.2 trillion, an amount equal to 14.9 percent of GDP. Federal revenue has ranged from 14.4 of GDP in 1950 to 20.6 percent in 2000 over the past five decades, averaging 17.9 percent.
The individual income tax has been the largest single source of federal revenue since 1950, averaging 8 percent of GDP.
Payroll taxes swelled following the creation of Medicare in 1965. Taxes for Medicare, combined with periodic increases in Social Security taxes, caused payroll tax revenue to grow from 1.6 percent of GDP in 1950 to 6 percent or more since 1980. Payroll taxes also include railroad retirement, unemployment insurance, and federal workers’ pension contributions.
Revenue from the corporate income tax fell from between 5 and 6 percent of GDP in the early 1950s to 1.3 percent of GDP in 2010.
Excise taxes fell steadily throughout the same period, from nearly 3 percent of GDP in 1950 to 0.5 percent in recent years.
The remaining sources of revenue have fluctuated less, together claiming between 0.5 and 1.0 percent of GDP since 1950 and standing near the bottom of that range in 2010.
Federal revenues are collected for the purpose of providing government services. Besides those expenses that are mandated (like Social Security, federal pensions and other entitlements), a large amount of money is spent annually on discretionary spending (which is those areas and services where Congress makes yearly decisions as to what services the government will spend on and how much will be spent for each. This is called discretionary spending and it tends to be the area with the most amount of debate and contention in both the Executive and the Legislative branches.
According to the National Priorities Project, the 2015 discretionary budget was set at more than $1.26 Trillion with money allotted to such services as the military and national defense ($640 Billion 55.2 percent), Education ($71.5 billion, 6.2 percent), Veterans Benefits ($65.5 billion, 5.6 percent), Government ($63.9 billion, 5.5 percent), Housing and Community ($63.9 billion, 5.5 percent), Medicare and Health ($56.7 billion, 4.9 percent), Social Security, Unemployment and labor ($56.1 Billion, 4.8 percent), Energy and Environment ($38.4 billion, 3.3 percent), International Affairs ($38.2 billion, 3.3 percent), Science and Technology ($29.2 billion, 2.5 percent), Transportation ($26.1 billion, 2.3 percent), Food and Agriculture ($12.8 billion, 1.1 percent). But these numbers are for new spending only and do not include already committed funds (nondiscretionary) such as interest payments on the federal debt and individual entitlements which amount to the approximately $2 trillion in spending and cannot be changed.
One of the most important jobs of Congress is to determine how federal revenue will be distributed and on which programs will receive priority funding. Of course, the president (who recommends a budget) and the members of Congress who vote on appropriations (how much will be spent on each federal program) rarely see eye to eye on the federal budget and this has been particularly true in recent years. Below is a chart with expenses for the 2015 Fiscal Year. A more detailed discussion of the budget process and the governmental policymaking process will be provided in a later section.
How income is collected and spent play a major role in determining overall economic policy for the United States. But just as important is an understanding of economic theory and how it is used to plan for and maintain a stable national economy. The following sections will discuss the economic theories and models used in the United States economic policymaking.
Macroeconomic Theories of U.S. Market Activities
Four macroeconomic theories of performance, structure, and behavior of markets have dominated U.S. governmental policies. The country’s varying degrees of successes and failures with each of these policies underscores the complicated and volatile nature of economic supply and demand.
Laissez-faire economics is the belief that economic markets should operate entirely free of government intervention in order to operate most effectively and efficiently. The term, sometimes referred to as “let it be economics,” hit its zenith in the U.S in the late 1800s during widespread industrialization. American businesses were able to operate virtually unencumbered from the government; however, by the early 20th century this policy resulted in shrinking competition as competing companies began to merge. President Theodore Roosevelt fought to “bust” unlawful monopolies and increase government regulation, especially in the booming railroad and oil industries. In addition, numerous laws were passed to regulate child labor, create safer working conditions, and institute price controls.
After the U.S. stock market crash in 1929, many blamed the unfettered capitalism of the 1920s; however, the causes were more complex. President Herbert Hoover attempted to stave off the depression with a number of government interventions that only exacerbated the problem (contrary to the historical view that he was a strong laissez-faire proponent). After Franklin D. Roosevelt was elected president in 1932 and established his “New Deal” policies, government intervention became the centerpiece of American economic policy.
Video: Sixty Second Economics: Laissez Faire (“The Invisible Hand”)
Keynesian economics is based upon the school of thought developed by John Maynard Keynes, a 20th-century British economist. Keynes’ central belief was that, in order to keep people employed, governments need to run up deficits during economic downturns through increased spending and tax breaks. Conversely, during prosperous times, governments should cut spending and institute tax hikes to curb inflation. The theory supposes a strategic interventionist role for the government in order to smooth out the bumps in market cycles. Keynesian theory was put to the test during the 1930s—the height of the Great Depression. President Franklin D. Roosevelt embraced the idea only after other policies failed to stimulate the economy. In one of his notable “fireside chats,” he explained to the American public that it was up to the government to “create an economic upturn” and make additions to the “purchasing power of the nation.” Precipitated by U.S. entry into World War II, Roosevelt increased deficit spending, which had the effect of lowering unemployment and increasing demand for war time labor.
For the next quarter century, Keynesian economics became the centerpiece of U.S. fiscal policy. The economy boomed until the late 1970s when inflation and an energy crisis shook the American public’s confidence in the Carter Administration’s ability to effectively address the problems. When Ronald Reagan became president in 1981, Keynesian economics fell out of favor.
Video: Keynsian Economics Explained (The Role of Keynes in the Great Depression)
Monetarism theory emphasizes that one of the most important roles of government is to control the amount of money in circulation. Monetarism gained strength during the 1970s as the country grappled with unprecedented inflation coupled with the supply “shocks” of increasing oil prices. Economists argued that Keynesian theory could not address the economic variations within a given system, such as changing rates of inflation, which are most often caused by increases or decreases in the money supply. In 1979, the Federal Reserve (the central banking system of the United States) announced that it would adopt a monetarism policy to stabilize the economy. The result was a deep recession in the early 1980s, although the policy did help to lower inflation. Monetarism was then abandoned in favor of a return to Keynesian policy.
Video: Monetarism Explained
Supply-side economics argues that economic growth can best be achieved by lowering barriers to production. More specifically, the supply-side economic theory rests on the notion that lowering tax rates and reducing business regulation allows for more flexibility, resulting in a greater supply of goods and services at lower prices. This theory developed as a direct response to Keynesian policy’s perceived failure to stabilize Western economies. However, its critics were quick to label it “trickle-down economics,” arguing that tax breaks and deregulation have a very
The most notable proponent of supply-side theory was Ronald Reagan; indeed, he made this theory the cornerstone of his economic policy known as “Reaganomics.” Upon assumption of the presidency in 1981, Reagan pursued an aggressive policy of reducing the growth of government spending (particularly on social programs), lowering income and capital gains taxes, increasing defense spending, tightening the money supply, and reducing government regulation. This economic approach was a marked departure from previous administrations.
The policies had mixed effects. The economy during the 1980s experienced significant turbulence despite generally favorable economic conditions. Interest rates, inflation, and unemployment fell significantly during this time; however, these were coupled with rising income disparities and a ballooning federal deficit. The success of Reaganomics continues to be debated by economists and policymakers alike.
Video: Supply Side (“Trickle Down”) Economics
- What role does economic policy play in the United States system of government?
- List and describe each of the economic goals for the United States government and give an example of how the government addresses each.
- What is the role of international global financial institutions and why are they important to U.S. Economic policy?
- What are the major sources of government revenue and expenditures?
- Which governmental expenditure accounts for the majority of discretionary spending (in 2014/15)?
- In your opinion is it more important for the federal government to spend money in the area of military spending or on domestic spending (social programs and governmental operations)? Explain and defend your answer.
- What are the four basic theories of economic policy? Which of these do you see as being the most effective? Why?