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Economic Policy

Instructional Objectives

1. Show how voters have contradictory attitudes regarding their own and others' economic benefits.

2. List and briefly explain four competing economic theories. Assess the nature and impact of Reaganomics

3. List the four major federal government agencies involved in setting economic policy, and explain the role of each.

4. Analyze federal fiscal policy in terms of the text's four categories of policymaking politics.

5. Trace the history of federal government budgeting practices up to the present day.

Lecture Notes

I. Economic health

A. Disputes about economic well-being tend to produce majoritarian politics
1. Voters see connections between nation as a whole and their own situations

2. Voting behavior and economic conditions are not always correlated at national and individual levels

a. People understand what government can and cannot be held accountable for

b. People see economic conditions having indirect effects on them even when they are doing well

B. What politicians try to do

1. Elected officials tempted to take short-term view of the economy

2. Government will not always do whatever is economically necessary to win the election

a. Government does not know how to produce desirable outcomes

b. Attempting to cure one economic problem often occurs at cost to another

3. Ideology plays large role in determining policy

a. Democrats tend to want to reduce unemployment

b. Republicans tend to want to reduce taxes

c. Both fear inflation, Republicans moreso.

II. Economic theories and political needs

A. Monetarism-asserts that inflation occurs when there is too much money chasing too few goods (Milton Friedman)
1. Advocates increase in money supply about equal to economic growth and then let free market operate

B . Keynesianism-government should create right level of demand

1. Assumes that health of economy depends on what fraction of their incomes people save or spend

2. When demand is too low, government should spend more than it collects in taxes

3. When demand is too high, government should increase taxes or cut expenditures

C. Planning-free market too undependable to ensure economic efficiency; therefore government should plan parts of a country's economy

1. Wage-price controls (John Kenneth Galbraith)

2. Industrial policy-government directs industrial investments (Robert Reich)

D. Supply-side tax cuts-need for less government interference and lower taxes (Arthur Laffer, Paul Craig Roberts)

1. Lower taxes would create incentives for investment

2. Greater productivity would produce more tax revenue

E. Ideology and theory

1. People embrace an economic theory partly because of their political beliefs

F. Reaganomics

1. Combination of monetarism, supply-side tax cuts, and domestic budget cutting

2. Goals not consistent

a. Reduction in size of federal government

b. Stimulate economic growth

c. Increase in military strength

3. Effects

a. Rate of growth of spending slowed (but not spending itself)

b. Military spending increased

c. Money supply controlled-cut inflation but allowed interest rates to rise

d. Personal income taxes cut; Social Security taxes increased

e. Large deficits incurred, dramatically increasing size of national debt

f. Stimulated economy-unemployment decreased, business activity increased

III. The machinery of economic policy making

A. Fragmented policy making; not under president's full control

B. Within the executive branch

1. Council of Economic Advisers (CEA)-members chosen are sympathetic to president's view of economics and are professional economists
a. Forecasts economic trends, analyzes issues

b. Prepares annual economicc report, president sends to Congress

2. Office of Management and Budget

a. Prepares estimates of amounts to be spent by federal government agencies; negotiates department budgets

b. Ensures that agencies' legislative proposals are compatible with president's program

3. Secretary of the Treasury-reflects point of view of financial community

a. Provides estimates of government's revenues

b. Represents nation with bankers and other nations

4. The Federal Reserve Board (The Fed)

a. Members appointed by president, confirmed by Senate; serve a nonrenewable fourteen-year term; removable for cause

b. Somewhat independent of both president and Congress

c. Regulates supply and price of money

C. Congress most important in economic policy making

1 . Approves all taxes and almost all expenditures

2. Consents to wage and price controls

3. Can alter Fed policy by threatening to reduce its powers

4. But also internally fragmented, with numerous committees setting fiscal policy

D. Effects of claims by interest groups

1. Usually majoritarian: economic health good for all

2. Sometimes interest group politics: protectionism in 1980s

IV. Spending money

A . Majoritarian, client, or interest group politics may result

B . Sources of conflict reflected in inconsistencies in public opinion

C. Politicians have incentive to make two kinds of appeals

1. Keep spending down and cut deficit

2. Support favorite programs of voters

D . Inconsistency of these appeals evident in budget

V. The budget

A. Earlier practices-not allocating revenues, just recording expenditures
1. No federal budget before 1921

2. No unified presidential budget until 1930s

3. Congressional committees continued to respond independently

B . Congressional Budget Act of 1974

1. Procedures
a. President submits budget

b. House and Senate budget committees analyze budget, with Congressional Budget Office

c. Budget resolution sets budget ceilings

d. Congress considers appropriations bills

e. Congress adopts second budget resolution that reconciles budget ceiling with total resulting from individual appropriations bills

2. Weakness: first resolution frequently ignored

C. Budget Reform and Policies

1. Reagan secured large cuts in 1981, but then unsuccessful

2. Passage of Gramm-Rudman Balanced Budget Act (1985) a. Called for

(1) A target cap on the deficit each year, leading to a balanced budget

(2) A spending plan within those targets

(3) If a lack of agreement on a spending plan exists, automatic across-the board percentage budget cuts (a sequester)

3. "Read my lips-no new taxes": Bush in 1988 campaign

a . Lack of presidential-congressional agreement almost produced a sequester of close to $100 million

b. To avoid this ...

(1) Increased taxes

(2) Cut in defense spending

(3) New budget procedures

c. But total spending went up almost 5 percent

4. 1993 budget bill

a. Caps appropriations in specific areas

b. Caps discretionary spending

c. Peace dividend not enough even to cover costs of inflation

d. Passed both houses of Congress without support of a single Republican vote

C. Difficulties in reducing spending

1. Interest group pressure to increase funds for programs

2. Much of budget is expenditures representing past commitments that cannot be altered (e.g., contracts, Social Security benefits, national debts): uncontrollable spending

3. Performance of economy unpredictable

VI. Levying taxes

A. Tax policy reflects blend of majoritarian and client politics
1. "What is a 'fair' tax law?" (majoritarian)
a. Tax burden is kept low
(1) Americans do pay less than citizens of most other democratic nations

b. Requires everyone to pay something

(1) Americans do cheat less than others

2. "How much is in it for me?" (client)

a. Requires the better-off to pay more
(1) Progressiveness is a matter of dispute: hard to calculate

(2) Many loopholes: example of client politics

3. Client politics (special interests) makes tax reform difficult

a. But Tax Reform Act passed (1986)

B. The rise of the income tax

1. Most revenue derived from tariffs until 1913 and ratification of Sixteenth Amendment

2. Taxes then varied with war (high), peace (low)

a . High rates offset by many loopholes: compromise

b. Constituencies organized around loopholes

3. Tax bills before 1986 dealt more with deductions than with rates

4. 1986: low rates with smaller deductions, upsetting the old compromise

C. The politics of tax reform

1 . Majoritarian politics resurfaced in demand for fairness

2. Several kinds of entrepreneurs involved

a. Professional economists opposing inefficiencies and inequities

b. Supply-side ideologists

c. Publicists exposing "tax cheats"

3. Success of policy entrepreneurs requires support of key politicians possible in 1986

4. Tax politics once again majoritarian, as in 1913

Discussion Questions

1. How does the nations economic health effect political behavior?

2. What is the role of politicians in regard to economic conditions and policy making?

3. Why is political ideology so influential in economic policy?

4. Which of the four economic thories best meets the needs of the nation? Explain and defend.

5. What was the effect of Reaganomincs on our national economy?

6. Why did the Republican Congress "shut down" the government in 1997?

7. How has Clinton gotten out of the budget crunch?

8. What agencies in the executive branch exist to manipulkate the economy and the budget?

9. What is the role of Congress in economic policy setting?

10 How has the Congressional Budget Reform Act of 1974 changed the budget process?

11. What has been the impact of budget reform since 1980?

12. What makes a "good tax?"

Important Terms

budget A document that announces how much the government will collect in taxes and spend in revenues and how those expenditures will be allocated among various programs.

budget deficit A situation in which the government spends more than it takes in, thus pumping more money into the economy.

budget resolution A total budget ceiling and a ceiling for each of several spending areas submitted by the Budget Committees in the House and Senate to their respective chambers. These resolutions serve as targets to guide the work of each legislative committee as it decides what should be spent in its area.

budget surplus A situation in which the government takes in more money than it spends, thus draining money out of the economy.

Congressional Budget Act of 1974 The law that altered the procedure by which Congress enacts the national budget. The Congressional Budget Office was established as a nonpartisan congressional agency. Budget committees were created in both houses, which then submit to each house a resolution proposing a total budget ceiling and a ceiling for each of several spending areas. Once these resolutions are adopted, individual appropriations are decided. Congress then adopts a second resolution reconciling the budget ceiling with individual appropriations bills.

Council of Economic Advisers A group of three professional economists who give the president expert advice on the economy. Created in 1946, it is responsible for forecasting economic trends, analyzing economic issues, and helping prepare the economic report the president submits each year to Congress. Since the president selects the CEA's membership, its recommendations usually reflect the ideological preferences of the president.

economic planning A somewhat socialistic economic theory that holds that the government should plan at least a part of a country's economic activity by wage and price controls or through industrial policy.

Federal Reserve Board A federal agency created in 1913 composed of seven "governors" who control the Federal Reserve System. The "Fed" is independent of both the president and Congress. Its most important function is to regulate the supply of money and therefore its value.

fiscal policy An attempt to use taxes and expenditures to affect the economy.

fiscal year October 1 to September 30, the period of time for which federal government appropriations are made and federal books are kept.

Gramm-Rudman Balanced Budget Act A law passed in 1985 which proposed cutting the budget until there was no longer a deficit. The deficit was to be reduced by a specified amount each year between 1986 and 1991. If a spending plan could not be agreed on within those targets, federal programs (with some exemptions) would automatically be cut by a fixed percentage. The procedure was abandoned in 1990.

industrial policy A form of governmental planning which became popular with academics in the 1980s and which maintains that the failure of smokestack industries to revive through market forces requires the government to direct investments. As a result, either these industries would recover or new industries would take their place.

Keynesianism A liberal economic theory developed by English economist John Maynard Keynes, who believed that economic health depends on the proportions of income which are saved and spent. The government's task is to create the right level of demand. When demand is too low, the government should pump money into the economy through spending on its programs. When demand is too great, the government should take money out of the economy by increasing taxes or cutting spending.

loophole politics A form of client politics involving deductions, exemptions, and exclusions by which people shelter some of their income from taxation.

marginal rate The percentage of the last dollar a person earns that must be paid out in taxes.

monetarism A conservative economic theory that holds that inflation occurs when too much money is chasing too few goods. Since the federal government has the power to create money, it should increase the money supply at a rate about equal to the growth in the economy's productivity; beyond that, it should leave matters alone and let the free market operate.

monetary policy An attempt to use the amount of money and bank deposits and the price of money (interest rate) to affect the economy.

Office of Management and Budget Created as the Bureau of the Budget in 1921 and made part of the executive office in 1939, its chief functions are to prepare estimates of the amount that will be spent by federal agencies, to negotiate with departments on the size of their budgets, and to make sure departmental and agency proposals are in accord with the president's agenda.

peace dividend Following the collapse of the Soviet Union, the expected sums of money freed up by cuts in post-Cold War defense spending that could be transferred to domestic spending.

price and wage controls The means of economic planning which reflect the belief that the government should intervene in inflationary times by regulating the maximum prices that can be charged and the wages that can be paid. Such controls would be imposed only on the largest industries.

Reaganomics The economic program instituted by President Ronald Reagan in 1981 which combined the theories of monetarism, supply-side tax cuts, and domestic budget cutting. The goal was to reduce the size of the federal government, to stimulate economic growth, and to increase American military strength.

secretary of the treasury Head of the Department of the Treasury nominated by the president and confirmed by the Senate. The secretary provides estimates of the revenue the government can expect from existing taxes and the projected revenues from changes in tax laws. The secretary also represents the United States in its dealings with the top bankers and finance ministers of other nations.

sequester A provision of the Gramm-Rudman Balanced Budget Act that requires an automatic, across-the-board percentage cut in federal programs-except for certain exempt programs-if the Congress and president cannot agree on a spending plan within a specified target set for that year by the law.

Sixteenth Amendment A constitutional amendment ratified in 1913 which authorized Congress to levy an income tax. The amendment was necessary because of a Supreme Court decision in 1895 which voided Congress's effort to impose such a tax.

supply-side theory A conservative economic theory that maintains that sharp tax cuts increase the incentive for people to work, save, and invest. The greater productivity of the economy stimulated by these increased investments would produce more revenue for the government despite the tax cut.

tariff A tax on goods imported into a country.

tax expenditures A term used by policy entrepreneurs denouncing tax loopholes as subsidies to groups that have not been made as appropriations through the normal annual congressional process.

Tax Reform Act of 1986 A law that effected a major change in tax policy resulting from the resurfacing of majoritarian politics that demanded fairness. Instead of high rates with big deductions, the law substituted low rates with much smaller deductions.

uncontrollable spending Budget outlays that are already committed and cannot be altered for either legal or political reasons. This spending includes contracts, payments to individuals guaranteed by law, and interest on the national debt. About three-fourths of governmental expenditures fall into this category.

Four major theories on the management of the economy are discussed in the text.

1. Monetarism. Monetarists such as Milton Friedman hold that inflation is the result of too much money chasing too few goods. This occurs when government prints too much money. When government tries to stop inflation by decreasing the money supply, unemployment increases. Rather than adopting these start-and-stop policies, it would be better if government allowed the money supply to increase steadily and consistently at a rate about equal to the growth in the productivity of the economy.

2. Keynesianism. For Keynesians, the market will not automatically operate at a full-employment, low-inflation level. When people spend too little, unemployment results, and government should pump more money into the economy by running a deficit (that is, by spending more than it takes in). When demand is too great, government should run a surplus. Thus an activist government fiscal policy is necessary.

3. Planning (price and wage controls, industrial policy). Economists such as John Kenneth Galbraith feel that large institutions in the economy (corporations and labor unions) have the ability to escape competitive pressures and raise prices, whatever the money supply or level of consumer demand. Thus the government must control wages and prices. But with the curbing of inflation in the 1980s and the voluntary lowering of wages and prices, a different type of planning by government was considered. Industrial policy reflected the federal government's desire to direct investment to declining but vital smokestack industries-steel and auto-in imitation of the Japanese model. This model was endorsed by Robert Reich.

4. Supply-side tax cuts. This relatively new theory, propounded by people such as Arthur Laffer and Paul Craig Roberts, holds that high taxes create inflation and economic stagnation by removing people's incentive to work. Thus cutting tax rates will encourage work and investment and even bring in more tax revenue as economic activity expands. This theory forms the core of Reaganomics.

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