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Chapter 16 |
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The political system involves collective decisions made by communities, states, or nations; and implemented through government coercion including laws, regulations, and taxes. A free-market economic system works through individual decisions made by consumers and firms, and relies upon voluntary exchange in the marketplace. The study of political economy deals with the proper relationship between governments and markets. All societies must decide how much to rely on government and how much to rely upon the marketplace to provide goods and services.
Economic Decision Making
Economic decision making involves both fiscal and monetary policy. Fiscal policy involves taxing, spending and borrowing policies of the national government, with the Congress and president sharing decision making responsibility. Monetary policy refers to decisions regarding the supply of money in the economy, including private borrowing, interest rates and banking activity. The Federal Reserve Board, which was established by Congress, has the primary responsibility for monetary policies.
The Constitution gives Congress the power to tax, borrow and spend money. There are no constitutional limits to Congress' power to spend or to borrow money. The president has no formal powers over taxing, spending or borrowing other than to make recommendations to Congress. The president has accrued influence in economic policy through his power to submit a budget to Congress.
The president's economic team includes the Office of Management and Budget, which plays a key role in setting the president's budget requests on behalf of the departments; the Department of the Treasury, which plays a key role in estimating revenues and preparing tax proposals; and the Council of Economic Advisors, which plays a key role in forecasting the economy and recommending policies.
Most economically advanced democracies have a central bank to regulate the money supply, currency in circulation and bank deposits. These banks are not run by elected politicians so as to remove the temptation to inflate the money supply. The Federal Reserve System of the United States is largely independent of either the president or Congress because it is run by a seven-member board of governors who are appointed by the president for fourteen year terms with consent of the Senate. The Fed's task is to regulate the money supply so as to avoid inflation and recession. The Fed actually issues the nation's currency, which are called "Federal Reserve Notes." The twelve Federal Reserve Banks hold the deposits of commercial banks, lend money to banks at discount rates, buy and sell Treasury bonds and assure regulatory compliance of private banks and monitors the health of the banking industry. The Fed influences the economy through its role in forging monetary policies. The Fed tightens the money supply and raises interest rates to fight inflation; when recession threatens, the Fed expands the money supply and lowers interest rates.
While the Fed sets the monetary policy, the president usually takes the blame when the economy performs poorly. Therefore, presidents and Congress often try to influence the Fed's decisions. Despite threats from Congress, the Fed usually maintains its role as a strong independent guardian of the money supply.
The Performance of the American Economy
Today the American economy produces about $40,000 worth of output for each of its 281 million citizens. The total of the nation's production in a given year, measured in market prices, is called the gross domestic product (GDP). Real GDP is the GDP measure adjusted for inflation. Prior to 1950, economic cycles of growth and contraction of the economy were characteristic, but since then economic swings have moderated substantially. The unemployment rate is measured each month by the U.S. Department of Labor on the basis of random sampling throughout the country. The unemployment rate tends to fluctuate with the business cycle, reflects recessions and recoveries, and lags behind GDP growth. Inflation means that the same dollars purchase fewer goods and services so it also reduces the value of savings and hurts those who are living on fixed incomes. In recent years the Fed has successfully kept down the rate of inflation as well as interest rates.
Economic Globalization
The American economy is a major force in the global economy. International trade has expanded greatly in recent decades. Since 1970 when exports and imports were only about 3 percent of gross domestic product (GDP), the United States has increased exports to about 11 percent of the value of its GDP and imports about 12 percent. Historically, the U.S. practiced protectionism by supporting high tariffs or taxes on foreign imports and quotas or limits on the number of units of specific goods imported into the country.
After World War II, the American economy became the most powerful and American businesses sought to expand their markets overseas. Trade barriers were lowered and free trade became a byword of American business. Results of the globalization of the American economy have been uneven. Low-skilled Americans met with economic hard times as they had to compete with workers in foreign countries willing to work at markedly lower wages. The gap between the rich and the poor in America widened dramatically. The lowest income families lost 22 percent of their real income, while the highest income families gained 33 percent in real income.
Congress has approved major treaties and organizations designed to institutionalize the global economy. Meanwhile, Democrats have expressed more reservations about free trade than Republicans, e.g., Democrats have called for "fair trade" in lieu of "free trade," and environmentalists have complained that foreign corporations are not government by strong or well-enforced environmental laws in their own countries.
Government Spending, Budget Priorities, and Debt
The three levels of government -- federal, state, and local -- collectively spend about 30 percent of the nation's gross domestic product (GDP). The federal government accounts for about 19 percent of GDP, or $2.4 trillion each year.
Growth in federal government spending is often attributed to uncontrollables in the federal budget. Uncontrollable spending refers to budget items committed by past sessions of Congress and not easily changed by the current Congress. These include:
1) Entitlement programs such as Social Security, Medicare, Medicaid, food stamps, federal employees’ retirement pensions, and veterans’ benefits.
2) Indexing of benefits to the inflation rate which pushes up entitlement spending each year, even if the number of recipients remains the same.
3) Increasing costs of in-kind benefits also guarantee growth in federal spending. Medicaid and Medicare costs have increased particularly fast because of escalating costs in the health sector.
4) Interest on the national debt, which is now 5.5 trillion dollars, has risen to 10 percent of federal spending.
5) Backdoor spending and loan guarantees refers to governmental spending that does not appear in the budget. For example, the Postal Service and Federal Housing Administration loans, which create obligations against the government.
Social Security and other entitlements, plus payments on the national debt, are examples of mandatory spending. These types of mandatory spending heavily outweigh discretionary spending, or spending on programs not previously mandated by law.
The national debt is the total amount owed by the U.S. government ($5 trillion; $20,000 for each American), payable to owners of Treasury bonds, 87 percent of them Americans. The deficit is the federal budgetary shortfall added to the national debt each year. In 1998, President Clinton sent the first balance budget to Congress in 30 years, thanks to a strong economy. The debt as a percentage of GDP was at its highest (over 100 percent of GDP) in 1945, due to the costs of WWII. The current national debt is equal to about 55 percent of GDP.
To pay its bills, the federal government floats the debt, which means it issues new bonds to obtain the revenue to pay off old bonds as they reach their maturity dates. In principle, the government could monetarize the debt by simply printing money to pay off its bonds, but that would lead to inflation and possibly disastrous hyperinflation. Although the national debt as a percentage of GDP is less than during WWII, huge interest payments on the national debt come from current taxes and divert money away from all other spending purposes. That is, the discretionary portion of the national budget would be much larger than it is were it not for the national debt. This in turn leads politicians into deficit financing to finance wanted government programs. Deficit financing shifts onto future generations the primary burden of present government services. An exceptionally strong economy cut the deficit to zero in 1998, but the large national debt continues to burden the country, the young in particular.
Surpluses lasted for four years – 1998-2001. During those years Democrats favored using revenue surpluses to pay down the national debt, expand Medicare to pay for prescription drugs, and protect Social Security. Republicans promised some form of all these things but favored spending part of the surplus on tax cuts such as cutting the top tax rates on the wealthy, eliminating inheritance taxes, and lowering capital gains taxes. Democrats charged such tax spending would mainly benefit the rich. Economists generally favored applying revenue surpluses to debt reduction, arguing that this would stimulate the economy: by reducing what government borrows, more funds are freed for private investment. The Republican-controlled Congress would not embark upon new spending and the Democratic President refused to go along with major tax cuts. The result was a stalemate and a modest automatic reduction in the national debt. An economic slowdown in 2001, the necessity of additional spending after the 9/11 terrorist attack, and (Democrats would argue) Bush’s deep tax cuts and tax rebates, brought back deficit spending.
The Tax Burden
Federal revenues come from individual income taxes, corporate income taxes, the Social Security payroll tax, estate and gift taxes, excise taxes and custom duties. Individual income taxes provide the largest single amount. Incomes are subject to payroll withholding at marginal rates which range from 15 percent at the bottom of the income ladder to 35 percent for those earning over $311,950 annually. The nation's poorest individuals pay no tax due to exemptions and the earned income tax credit (but they do pay Social Security taxes).
Half of all personal income is not taxed because of permitted exemptions, which are a form of tax expenditure akin to a federal subsidy except instead of giving the recipient a check, the federal government simply does not collect tax from that individual in the first place. Exemptions include those for mortgage interest, dependents, property taxes, deferral of capital gains on home sales, charitable deductions, child-care expenses, income earned abroad, and accelerated depreciation of business equipment and structures.
The corporate income tax provides 10 percent of federal revenue. It was decreased from 46 percent to 34 percent in 1986, then raised to 35 percent in 1993. Due to loopholes, many profitable corporations pay little in taxes. Social security taxes are paid by the FICA deduction in paychecks and by employer contributions. Taken together, FICA and employer deductions for Social Security are a larger amount than the income tax itself for most individuals. Federal estate taxes begin on estates of $650,000 (scheduled to rise to $1 million in 2006), and there are federal gift taxes on gifts over $10,000 per year. Excise taxes and custom duties on gasoline, tobacco, liquor, telephone services, and other items provide another 3 percent of federal revenue, pushing up the consumer cost of imported goods. Overall, however, when compared to some other industrialized countries, the tax burden in the United States is lower.
Tax Politics
Tax politics focus on the question of who bears the heaviest burden of tax or which income groups devote the largest proportion of their income to taxes. Progressive taxation is a system of taxation in which higher income groups pay not only more taxes in absolute terms, but also pay a higher percentage of their incomes. Regressive taxes take a larger share of income from lower-income individuals. Proportional taxation advocates, such as politicians who argue for a flat tax, contend that equity demands each person pay the same percentage.
Progressive taxation is defended on the moral ground that asking those that are more able to pay a higher percentage is the only way to equalize the sacrifice involved in taxation. Proportional taxation advocates, such as politicians who argue for a flat tax, contend that equity demands each person pay the same percentage. Progressive taxes, they say, penalize economic entrepreneurship and risk-taking and divert money which the wealthy would otherwise invest back into the economy. As a step in this direction, Reagan-era reforms in the 1980s replaced the 14-tier progressive system, which went up to 70 percent on the very wealthy, with a two-tier system of 14 percent and 28 percent. The Clinton administration, while it still had a Democratic Congress prior to 1994, pushed rates back up to 15 percent to 39.6 percent in a five-tier system.
Proportional tax advocates point out that in absolute terms, the higher rates do not raise a large share of the federal budget simply because there are not large numbers of very high-income taxpayers. These advocates prefer lower rates for the wealthy, arguing this will promote economic growth and benefit everyone. Their critics, in turn, point out that there is no close correspondence between the economic growth rate and the marginal tax on the wealthy.
Early in his administration George W. Bush was successful in pushing a major tax reduction through Congress. This legislation included calls for additional tax reductions in future years – through 2010. Once deficit spending returned, Democrats began to argue that these expected future tax cuts should be curtailed to end deficits.
The Republican Party frequently urges reductions in the rate at which capital gains (investment profits) are taxed. Some reformers, temporarily victorious in the Tax Reform Act of 1986, see no reason why earned income and capital gains income should be taxed differently. However, under the Bush Administration in 1991, the top rate on earned income was raised to 31 percent while leaving capital gains at 28 percent. The 1993 Clinton tax reforms raised the earned income rate to 39.6 percent, but also left capital gains at 28 percent.
Since then, the Republican Congress has lowered the top capital gains tax to 20 percent, arguing this boon to investors will help everyone by promoting economic growth. Critics call this a form of "trickle-down" economics which only benefits the rich. George W. Bush has continued this trend by lowering the tax rate even further because he argued the tax reduction would spur the economy and spending. In addition, he pushed tax cuts on stock dividends, removed the marriage penalty, raised the child tax credit and reduced the capital gains tax to 15 percent. These tax cuts were not made permanent but must be renewed in 2005.
The federal income tax is still highly progressive. The top 10 percent of income earners pay 69 percent of all individual income taxes, while the lower half pays only about 4 percent of the total income taxes paid.
Chapter Objectives
After mastering the concepts in this chapter, you will be able to
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