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Fiscal Policy Primer

March 24, 2015

Here at Wonk Tank, one of the primary areas of public policy that we will be focusing on is the all-important area of fiscal policy. But in order to analyze some of the vastly complex and in-depth issues surrounding fiscal policy, it’s important to first understand what it actually is. Welcome to Wonk Tank’s Fiscal Policy Primer.

The US Capitol Building

 

What is Fiscal Policy?

For our purposes, fiscal policy can be defined as the decisions governments make about raising and spending money in order to direct the economy and maximize social welfare.

Let’s divide the above definition into two separate parts: first, we’ll look at how the government raises revenue, then we’ll analyze how and why they spend it.

How Governments Raise Revenue in the United States

Project Tax Revenue 

The primary method by which governments raise revenue is through taxation. Different levels of government are funded primarily by different types of taxes. Local governments rely mostly on property taxes – taxes paid by owners on the value of their property – though many have individual income taxes – where people pay a certain percentage of their income to the government – as well. State governments are funded largely through income and sales taxes: a flat percentage tax on the price of a purchased good. The federal government is primarily funded by income and payroll taxes, which are also paid as a percentage of one’s income, but are usually partially paid by employees and partially by employers. These taxes often go to mandatory spending social insurance programs like Social Security, Medicare, and Unemployment Insurance – which we’ll get to later on.

Sources of Federal Tax Revenue

  A few other types of taxes to be aware of:

  • Corporate Income Taxes: The United States, like other developed nations, charges income taxes on corporations as well as individuals. However, the US corporate tax code has been repeatedly criticized as being riddled with loopholes that prevent corporations from having to pay their full tax burden.
  • Capital Gains Taxes: Capital gains are the monetary returns of a given capital asset, such as a stock or bond. The federal government taxes those returns when the asset is sold, though generally at a lower rate than it taxes other forms of income in order to encourage investment in asset markets. Capital gains taxes are complicated, and the tax rate can change depending on how long the asset is left to mature. Here is an excellent primer on the difference between short-term and long-term capital gains taxes.
  • Excise Taxes: These are taxes paid on the purchase of a specific good. For example, the United States Highway Trust Fund, which is responsible for building and maintaining our highway infrastructure, is funded by a tax on the purchase of gasoline.
  • When excise taxes are placed on certain items in order to discourage their consumption because the good is viewed as somehow socially undesirable, they are often called sin taxes. Classic examples of sin taxes include state and federal taxes on cigarettes, and many state and local taxes on gambling or alcohol.

Cigarette Taxes and Cigarette Consumption in the US

  • Tariffs: These are fees (usually assessed as a percentage of the price of a given good) on imports or exports of certain goods – or to or from certain countries. In the eighteenth and much of the nineteenth centuries, the majority of the US federal government’s revenues came from tariffs designed to help promote American businesses by driving up the prices of foreign goods. But as the economy has become increasingly globalized and trade increasingly liberalized, tariffs are now a largely insignificant source of revenue.

Tariffs as a Percentage of Total Federal Budget 

How Governments Spend Money in the US

How Governments Spend Money in the US
In this section, we’ll look at the breakdown of how the government spends its money. In this case, we’ll focus exclusively on the federal government because it’s not realistic to look at all fifty states’ different budgets. However, in the future we’ll be writing more in depth about different states and programs they fund.

One thing to note about federal spending is that contrary to what you may hear from politicians or the news media, we are not seeing unprecedented levels of government spending and deficits under Presidents Obama and Bush. Yes, technically federal spending has increased massively over the past few decades, but when viewed as a percentage of the total size of the economy (measured as Gross Domestic Product here), it has remained fairly constant – and certainly far below its peak levels during World War II. The same goes for US budget deficits. It’s certainly something to keep in mind when listening to politicians’ rhetoric about soaring spending and debt.

President's Proposed Total Spending 

  Now, the important thing to understand about the federal budget is that there are two main types of federal spending (unless otherwise stated, the charts in this section all come from The National Priorities Project’s stellar breakdown of President Obama’s 2015 federal budget proposal):

Projected Mandatory and Discretionary Spending and Interest on Federal Debt

  • Mandatory spending is spending that does not have to be reauthorized or re-budgeted every year. Mandatory spending sometimes has its own explicit funding source, such as a trust fund, and spending expands or contracts as needed, essentially functioning on its own with no intervention from Congress (that is, unless the revenue sources themselves run out or need to be reformed to avoid that fate). Mandatory spending makes up a significant majority of total federal spending, specifically 65% in fiscal year 2015. As you can see in the chart below, the overwhelming majority of that mandatory spending goes to the Social Security, Unemployment Insurance, and federal healthcare programs Medicare and Medicaid.

President's Proposed Mandatory Spending 

  • Discretionary spending is the kind of spending outlined every year in a Congressional appropriations bill, which authorizes the government to spend money and budgets various federal agencies, initiatives, and grant programs. The chart below outlines President Obama’s proposed discretionary funding levels for 2015. A few things to note about discretionary spending in general:
  • Discretionary spending is dominated by defense spending, which in the United States is far higher than it is in any other country in the world.

  • Only about 3% of discretionary spending goes towards international affairs, including foreign aid – which is by far the program Americans most want to see cut.

  • Non-defense discretionary spending has actually been consistently decreasing as a percentage of GDP for the last few decades. The growth in federal spending and budget deficits and debt (outside of stimulus initiatives during recessions) has been almost entirely due to increases in mandatory spending due to an aging population collecting more Social Security and Medicare benefits, as well as expanding social insurance programs during recessions.

President's Proposed Discretionary Spending

 

  

How Does Fiscal Policy Impact the Economy?

Well… that’s the question, isn’t it?

The decisions of how to appropriate, budget, and spend are some of the most fiercely fought partisan battles in Washington today. Democrats and Republicans have vastly divergent viewpoints about the effectiveness of government spending at stimulating the economy, the impact of deficits and debt, and the extent to which the government should use fiscal policy to redistribute income. These are the very kinds of issues which we hope to analyze in depth in the coming weeks and months here at Wonk Tank. Here, however, we’ll provide a very brief overview of some theories of fiscal policy, first with regard to economic stimulus (or the size of the economy), then with regard to equity.

Fiscal Policy as Stimulus

The classic liberal argument for government spending is the Keynesian model. Proposed by British economist John Maynard Keynes, it holds that government spending should be counter-cyclical to the state of the economy – that is, spending should increase when the economy is in poor shape, and decrease when it’s healthier.

The Keynesian model relies on concepts called aggregate supply and demand, or the economy’s total supply of and demand for goods and services. Keynes proposed that when the economy is in poor shape, it enters a vicious circle: people have less money, thus they demand fewer goods and services. Firms thus supply fewer goods and services, and cutting back production means cutting costs by laying off workers. This causes workers to have even less money, which further reduces demand – and so the cycle repeats and reinforces itself, causing a structural depression.

In the Keynesian model, governments can use fiscal policy to boost aggregate demand and return production to its pre-recession levels. In this system, the government can run budget deficits (when spending is higher than tax revenues) by issuing Treasury bonds that can then be repaid when the economy is in better shape. (For more on debt financing, stay tuned for our monetary and financial policy primer.) Governments can boost aggregate demand directly through spending: for example, on infrastructure projects that create jobs (this was the basis of the New Deal during the Great Depression), or on tax credits or social insurance programs that keep people from falling into poverty. Classic examples of Keynesian fiscal stimulus policy include the aforementioned New Deal, as well as the American Recovery and Reinvestment Act passed during the recent financial crisis. After the Great Depression and the New Deal, Keynesian economics became a mainstream, widely accepted economic viewpoint, and for good reason: there is ample evidence that fiscal stimulus is an effective tool at creating jobs and boosting aggregate demand during economic crises.

However, it would be foolish to argue that a consensus has been reached. Many (mostly conservatives, but some liberals too) are skeptical of Keynesian fiscal policy theory.

Here’s the basic intuition of Keynesian skeptics: fiscal policy doesn’t actually add money to the economy. Rather, it transfers it. Each dollar the government injects into the economy is at some point taken out through tax payments, so the long term effects of fiscal policy are economically neutral.

Keynesian skeptics view economic recessions as an unavoidable consequence of the business cycle: the natural fluctuations of the economy. There will be boom years and there will be bust years, and it’s not the government’s job to fix that. Additionally, Keynesian skeptics view fiscal policy as economically inefficient. According to classical economic theory, aggregate demand will equilibrate, or return to its natural level, of its own accord. In a receding economy, inefficient businesses will naturally die, while new, innovative businesses that are able to manage costs and deliver a unique product will succeed. Thus, economic resources such as investment capital will naturally flow to the newer, more efficient businesses, which will then hire the laid off workers from older, inefficient businesses, and return the economy to its natural production levels.

Aggressive fiscal policy interferes with this process: it finances government spending with tax money that could otherwise be used as investment capital. Thus, Keynesian skeptics would argue that fiscal policy simply props up inefficient businesses and prevents resource flow to new businesses, counter to the natural business cycle. Instead of spending counter-cyclically during recessions, they argue, governments should prioritize their financial stability by imposing austerity, or budget and revenue cuts that prevent the government from running a financially unsustainable deficit and racking up long term debt.

Keynesian supporters, however, have their doubts. The main argument against classical economics, with its ideas of economies always equilibrating to their natural level of output, is that certain shocks and crises can create barriers to the flow of investment capital and other resources to new businesses. For example, many of the last few centuries’ economic crises have been manufactured by an asset bubble – a certain capital asset that investors get overly excited about, artificially pump up its value by overinvesting, then suffer when the asset values inevitably collapse. The Great Depression involved overspeculating on the stock market, the dot com burst of the early 2000’s involved excessive investment in internet companies, and the most recent financial crisis was started by collapsing housing prices. When a particular asset bubble bursts, it causes ripples through other asset markets, and in catastrophic scenarios can destroy massive amounts of wealth – think the Great Depression when the stock markets and banks collapsed, wiping out millions of people’s savings. Keynesians argue that this destruction of wealth is what prevents capital from flowing to new businesses and prevents the economy from equilibrating – if there is no capital to invest, how will new businesses get off the ground, hire workers, and grind the economy back into motion?

Classical economists, on the other hand, argue that capital markets, just like consumer ones, will recover on their own, as new financial products and assets are found and targeted for investment. There is also a question of just how long-run we are talking about, because as the economy is adjusting and recovering, there are millions of people out of work. How do we balance the trade-off between more employment through fiscal stimulus in the short run, and a more efficient economy in the long run? These are questions without easy answers.

A perfect example of this divide between Keynesian and classical economists are the federal bailouts of financial institutions and automotive companies during the recent crisis. Proponents argued that letting the automotive companies die would depress aggregate demand so much that it could permanently harm the economy, and that allowing financial institutions to collapse would cause a massive destruction of wealth and prevent natural forces from equilibrating, while opponents argued that the government was improperly bailing out inefficient businesses that should be left to die.

A newer, smaller left-wing movement called Modern Monetary Theory is also gaining traction. MMT shares the same roots as Keynesian ideas of boosting aggregate demand with government spending. However, unlike traditional Keynesians, MMT proponents believe the government should always be running at a deficit, even during stable economic times. They believe any surplus the government has is money that could be reinvested into the economy; if it isn’t, it creates an inefficient fiscal drag. It may seem ridiculous to argue that the government can spend more money than it takes in and continue to rack up debt in perpetuity, and it’s true that MMT is a minority position among economists, but it’s not as crazy as it sounds because the United States has a monopoly over its own currency supply – which means that it will arguably always be able to pay back its debts, provided the country remains politically stable and sovereign. We’ll talk more about why running a consistent deficit could actually be sustainable for the United States in our financial and monetary policy primer, but if you want an excellent look at MMT, this Washington Post article is well worth the read.

Which side is correct? There is no one definitive answer, but at Wonk Tank we’ll be studying and analyzing these issues closely. Stay tuned.

The Equity Argument For Fiscal Policy

Even if one accepts the conservative argument that fiscal policy does not, in the long term, have a net effect on economic output, there are many who still believe it creates economically beneficial equity gains.

The reasoning behind this is that our taxation system is progressive: the higher your income, the higher your tax rate is. Thus, fiscal policy initiatives are generally redistributive in nature. Consider the construction of a road, a classic example of infrastructure investment. The project is financed disproportionately by tax dollars from the rich because of progressive taxation; however, the tax money is spent to hire construction companies and workers – creating many middle class jobs – and the road itself can be used equally by people of any class once it is built. Another example is education spending. Statistics show that the rich generally have fewer kids than the poor, but progressive taxation (and the higher value of their homes and property taxes) ensures that they bear more of the burden of paying for public schools that educate children of disproportionately less well off parents. Thus, fiscal policy can often be thought of as a transfer from the rich to the less well off.

Some view this as an economic good: they see the unregulated economy as one that disproportionately directs money and resources to the rich, and therefore one of the government’s primary goals should be a more equitable distribution of resources through fiscal initiatives. Others believe that the rich simply have a social responsibility to contribute to the less well off.

Still others think the economy is better off with transfers: the intuition behind this is that if you have a million dollars and earn a thousand, you will probably save that money because your needs are already taken care of, but if you only have ten thousand and you earn a thousand more, you are more likely to spend it on something that you need. This spending is what drives a market economy. This is the theory of diminishing marginal utility: the more of a certain good (in this case money) that you already have, the less an additional unit of that good improves your welfare – i.e. the less utility another unit (called the marginal unit) provides.[1]  

However, the counterargument to this is that the rich are more likely to invest that thousand dollars in, for example, stocks or bonds in new businesses. That investment gives new businesses cash that they can use to produce more goods and services, and create more jobs. This is the theory of supply side economics.

In this case, the optimal level of resource transfer by the government comes down to your personal values – i.e., how much transfer achieves the proper level of social equity. We can’t make that judgment for you, but we can and will give more context around policy issues of transfer payments, as well as the effect of transfers on the economy writ large.

Summary

Fiscal policy is a complicated thing when we move from positive statements about how it works to normative statements about how it should work. Here at Wonk Tank, we will aim to give our readers a greater understanding of the more in depth issues involved, so that you can develop your own opinions about how the economy and the government should work. This is just a primer that barely scratches the surface of the deeper issues involved.

For more, stay tuned.

 _________________________________________________________________________

  [1] To better illustrate the concept of diminishing marginal utility, think about pizza. When you are really hungry, that first piece of pizza you eat provides a high degree of utility, or value, to you. However, as you eat more and more pizza, you get fuller and fuller so that each subsequent slice of pizza provides less and less value. At a certain point, say perhaps the fifth slice, you may decide that you are so full that an additional slice of pizza may actually make you worse off – perhaps the additional calories are not worth the additional satisfaction of eating another piece. Economists call this the satiation point.

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  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

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RESOURCE SPOTLIGHT:

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