Economic Tools of the US Government

1
Economic Tools of the US Government

• American Budgetary and Fiscal Policies

2
I. The Federal Budget An Overview
Who pays? Who gets what?
3
Reminder The Macroeconomic Effect of Fiscal
Policy

• Government policies that increase aggregate
  demand are called expansionary policies.

• Government policies that decrease aggregate
  demand are called contractionary policies.

4
A. Revenues Microeconomic Effects (Who pays?)
1. Tax code is best place for political
favors. Why? a. Permanence -- Tax law remains
unless someone repeals it. Spending requires
reauthorization every year. b. Less visible --
Public doesnt understand tax code
5
2. Class differences a. Progressive taxes
(Wealthy pay higher of income)

• Income Tax Tax on earned income. Does not apply
  to investments.
• Capital-Gains Tax Tax on investment income.
• Estate Tax Tax on wealth over 1.6 million (3.2
  million if married) after death (2006 figures)

6
Class differences b. Regressive taxes (Poor pay
higher of income)

• Excise Taxes Tobacco, Alcohol, Gasoline, etc.
• Exception may be gasoline taxes (Multiple cars,
  Low Fuel Economy for SUVs)
• State Taxes
• Sales tax (poor consume larger fraction of
  income)
• Property tax Effect on rent tends to make tax
  regressive (poor pay larger share f income for
  housing)
• Depending on definition
• Payroll Tax Social Security and Medicare taxes.
  Paid only on the first 90,000 of wages. Not
  paid on investments or on wages over 90,000
  (2005 figure).

7
Class differences c. Flat Taxes

• Also known as Proportional Taxation
• Definition Everyone pays same of income,
  regardless of source
• US System
• Consists of progressive and regressive taxes
• Federal taxes gt State taxes
• Only moderately progressive Middle income range
  is nearly flat
• If progressive taxes become flat taxes, overall
  system becomes regressive

8
(No Transcript)
9
State and Local Taxes Regressive
10
Is the US Tax System Flat?
11
d. Which federal taxes are most important?
12
B. Spending Who gets what?
13
1. Categories of Spending

• Mandatory About 2/3 of the Budget

• Discretionary About 1/3 of the budget

14
a. Mandatory Spending

• Some laws commit Congress to spend money in the
  future. These programs get funding each year if
  Congress does nothing
• Social Security
• Medicare
• Medicaid
• Income Security
• Interest

15
Mandatory Spending Increases Every Year
16
partly due to new benefits
17
but mostly due to an aging population
18
and increasing health care costs.
19
Interest will grow as well.
20
b. Discretionary Spending

• i. Must be renewed by Congress or funding ceases
• ii. Defense is largest discretionary expenditure

21
iii. Defense Spending Stability and Change
22
iv. US vs. Everyone Else
23
C. Programs of Interest

• These are already included in the earlier figures
  
• BUT
• These programs have generated public and
  Congressional debate out of proportion to their
  budgets

24
1. Programs of Interest Homeland Security
25
a. Department Creation Must Pass Perfect
for Interest Groups

• i. Unrelated Amendments
• Eli Lilly Immunizes drug makers from lawsuits
  over vaccines
• Allows formerly American companies that move to
  foreign tax havens like the Cayman Islands to win
  federal contracts
• ii. Winners
• Technology companies (databases)
• Shipping / Trucking / Air companies (subsidized
  security)
• Corporate tax evaders
• Eli Lilly and other vaccine manufacturers
• iii. Losers
• Airport screeners (no unions allowed)
• Plaintiffs suing over old vaccines

26
b. Large Increases in Funding Further
Opportunities for Interest Groups

• Authorized in the FY2004 budget
• 2,000,000 to the Great Lakes Region to purchase
  an Icebreaker so that commercial ships can go
  through during the winter
• 200,000 to project Alert, a school-based drug
  prevention program for middle grade youth.
• 2.5 billion for highway security, which
  consists of building and improving roads.
• 70,000,000 for the Homeland Security Fellowship
  Program for students and universities.
• 50,000,000 to the National Exercise Program to
  provide an exercise program that meets the intent
  of the Oil Pollution Act of 1990.
• 6,400,000 for the Intellectual Property Rights
  Center. The centers focus is to combat
  intellectual property right crimea long time FBI
  project.

27
2. Programs of Interest Welfare

• a. No budget for welfare
• Social welfare programs include Social Security,
  Medicare, Medicaid, many others
• Most people mean cash, food, and medical aid to
  the poor Means-Tested Assistance
• b. Jointly funded States pay about one-third

28
c. Welfare Reform Cases have gone down.
29
and more single mothers are working outside the
home.
30
but putting them to work is expensive!
31
d. Where does TANF money go?-- Less cash than
AFDC, more Child Care and Work
32
e. TANF ? State flexibility Many states spend
money on unique programs
33
3. Programs of Interest Foreign Aid
34
(No Transcript)
35
a. US Gives Very Low of GDP for development
36
but still manages to be the largest donor
37
b. Top Three Recipients of US Aid FY 2000 FY
2007
Israel and Egypt are two of the top three every
year for the past 25 years. Why?
38
4. Programs of Interest Research
39
D. Budget Deficits

• Definition Spending gt Revenue
• Balanced Budget No Budget Deficit
• Technically, no surplus either, but no one
  objects to a little surplus.

40
1. Dangers of Budget Deficits

• Interest payments If economy grows slower than
  interest paid on debt, interest becomes larger
  fraction of GDP
• Reduced private investment Government borrowing
  tends to reduce overall savings and crowd out
  private investment
• Increased interest rates All else being equal,
  government borrowing raises the cost of borrowing
  for everyone else
• Key variable Does deficit spending generate high
  enough real growth (growth after inflation) to
  offset future interest payments and decreased
  investment?

41
2. Recent History Brief Surplus Followed By Deep
Budget Deficits
42
3. The National Debt Accumulated Deficits
43
(No Transcript)
44
4. Who Does the US Owe?
45
E. Who is Responsible?

• Formal procedure
• Since 1921 (Budget and Accounting Act) Budget
  submissions by President focused responsibility
• Since 1974 (Budget Act) Competing Congressional
  budget resolutions diffused responsibility
• Informal process Veto gives President power to
  prevent higher spending, but not to raise
  spending (use of continuing resolutions can
  prevent spending increases)
• Relationship between requests and authorization
  Congress usually appropriates about what the
  President requests

46
(No Transcript)
47
Mandatory Spending Binds Both Branches
Presidential Requests (Solid) vs. Congressional
Authorization (Dashed)
48
National Security Funding Does Congress Follow
the Leader? Presidential Requests (Solid) vs.
Congressional Authorization (Dashed)
49
Discretionary Spending Congress Frequently
Alters Presidential Requests
50
4. Public Opinion

• a. Low Salience Balanced Budgets Dont Win
  Elections

51
b. Popular Reaction to the Budget Deficit

• Voters generally assign blame/credit to President
  for economy, not Congress. BUT
• 1988 study Voters who listed deficit as critical
  issue more likely to vote Republican (Reagan not
  blamed for 1980s deficits or people voting
  prospectively for Bush?)

52
5. Partisanship and the Deficit

• Division of government between parties increases
  deficit
• Moderates of both parties most likely to vote for
  both higher taxes and lower spending
• Comparison of projections by the Federal Reserve
  Board, Congress, and the Executive finds that
  Executive estimates are least reliable
• Democratic Presidents exaggerate unemployment
• Republican Presidents exaggerate inflation
• No clear partisan divide on growth estimates
  until 1980s Reagan/Bush I were too optimistic,
  Clinton was too pessimistic

53
II. Monetary Policy The Federal Reserve Board
and the Banking System

• A. The Federal Reserve Board

54
1. Organization of the Federal Reserve System

• Federal Reserve System created by action of the
  U.S. Congress in 1913
• Prior to 1913, U.S. had no Central Banking System
• Occasional Financial Panics (1880s, 1890s, and
  finally, 1907) Public demanded that government
  take steps to prevent such panics
• The Federal Reserve System to become the lender
  of last resort should commercial banks begin to
  fail

55
2. The Federal Reserve Districts

• Each of the 12 Federal Reserve District Banks is
  owned by the member commercial District Banks in
  its District
• Fed is a quasi public-private enterprise, not
  controlled by the President or Congress

56
3. The Board of Governors

• Seven Members appointed by the President
  confirmed by the Senate
• Appointed for a single fourteen year term
• A Board position is scheduled for replacement
  every two years
• Chairman is public voice of Federal Reserve
  Board, but is only one vote

57
The Federal Reserve System

• Board of Governors
• 7 appointed members
• Appointed by President
• Confirmed by Senate
• Sets reserve requirements
• Supervises regulates member banks
• Establishes and administers regulations
• Oversees Federal Reserve Banks

• 12 District Banks
• Propose discount rates
• Hold reserve balances for member institutions
• Lends reserves
• Furnish currency
• Collects clears checks
• Handle U.S. government debt cash balances

Federal Open Market Committee (Board of Governors
plus 5 Reserve Bank Presidents. This committee
directs open market operations which are the
primary instruments of monetary policy
58
4. Functions of the Federal Reserve

• Conduct Monetary Policy
• Formal mandate Low inflation and Low
  Unemployment
• Actual policy emphasizes low inflation over full
  employment or economic growth
• Serve as a lender of last resort to commercial
  banks within the District
• Issue Currency In God we Trust
• Provide Banking Services to the U.S. Government
• Supervise and regulate financial institutions

59
B. Monetary Policy - How it works
60
1. The FRBs Toolkit

• Buying/selling government securities
• Stimulation Fed purchases U.S. Government
  Securities in the bond market (U.S. Treasury
  Notes) Raises bond prices reduces interest
  rates
• Cash flows from the Fed to sellers of bonds
  sellers deposit cash in their banks, thereby
  increasing the nations deposits and the excess
  reserves of the banking industry
• Restraint Fed sells U.S. Government Securities
  in the bond market (U.S. Treasury Notes) Lowers
  bond prices increases interest rates
• Cash flows from the banks to buyers of bonds and
  ultimately to the Fed, thereby reducing the
  deposit accounts and restricting the ability of
  commercial banks to loan money

61
b. Alter the Fed Funds Rate /Discount Rate

• Fed Funds Rate the interest rate commercial
  banks must charge one another to lend or borrow
  on an overnight basis for reserve management
  purposes
• Discount Rate the interest rate commercial banks
  must pay the Fed to borrow directly from the Fed
  for reserve management purposes

62
c. The reserve rate The Feds ultimate weapon

• Use of this tool would be perceived as a reaction
  to extraordinary events
• Amount of cash banks have to keep on hand to
  cover withdrawals
• Fed will be very cautious and publicize its
  intentions well in advance
• Last time required reserves changed 1980
  resulted in a credit crunch that plunged the
  economy into the worst recession since the Great
  Depression

63
2. The role of Banks in Monetary Policy

• a. Banks Create Money Banks can be viewed as
  counterfeit operations authorized by the
  government, and are an essential tool in
  affecting monetary policy
• Banks lend money that they dont have -- so they
  are essentially minting their own currency!
• Reserve requirements set by the government
  determine the extent to which banks can
  counterfeit

64
b. Banks depend on confidence

• Customers could bankrupt a bank simply by asking
  for all of their reserves back, which they can do
  at any time.
• Customers dont ask for their money back when
  counterfeiting is profitable and they earn a
  part of the returns (interest)
• Customers will tolerate the behavior only as long
  as they believe that the bank is reputable in
  this activity

65
c. Money creation through fractional reserves
The money creation process Making one loan
creates the opportunity to make another loan, a
process which continues in perpetuity. Step 1
Bank issues a promissory note for which there is
no direct reserve. (ie. the bank makes a loan
and gives the borrower a receipt against that
banks reserves) Step 2 This receipt (loan) is
traded for a good or service (promissory note is
passed on to a new holder) Step 3 The
promissory note is deposited back into a bank by
the new holder, creating a new deposit (bank
liability). Step 4 The promissory note is
available once again to be loaned.
66
Money Creation Example

• A bank receives 100 Million in deposits, keeps
  20 million in reserve.
• But the 80M in loans returns to the banking
  system somewhere else -- the second generation
  bank

The third generation bank receives 64 million of
new loan deposits, allowing another 51.2 million
in loans
67
Money creation in perpetuity
68
3. Effectiveness of Monetary Policy

• Easy to curb inflation, at cost of lower growth /
  recession and increased unemployment
• Harder to stimulate growth
• Fed can lower interest rates, increase the banks
  deposits BUT
• It cannot force a broke person (business) to
  borrow
• Good risks in prosperous times become poor risks
  in recessionary times
• Fed ability to stimulate often compared to
  problem of trying to push a string no matter
  how much effort you give it, it just doesnt move
  much