American Politics Today - Essentials (3rd Ed)

ECONOMIC POLICY| 439

then. Supply-side economics focuses on the ways that tax policy and regulations
aff ect the labor supply rather than on these policies’ impact on overall demand.
The primary focus is on the way tax rates aff ect how much people work rather
than how they spend. The idea is that if tax rates are too high, people will work less
because a large percentage of their income goes to the government.
However, when taxes were cut under Reagan, with the top marginal rate (the
income tax rate paid on the top slice of earned income) going from 70 to 50 per-
cent, revenue fell and the budget defi cits exploded. Supporters of the supply-side
theory argue that the problem was on the spending side of the equation rather than
on tax revenue. While overall government spending did increase during the 1982–
83 recession, spending from the beginning of Reagan’s term to the end dropped
slightly from 22.2 percent to 21.2 percent of gross domestic product (GDP), a nd
tax revenue fell from 19.6 percent of GDP in 1981, the last year before the tax cuts
went into eff ect, to 18.1 percent of GDP in 1988, the last year of the Reagan presi-
dency.^13 This observation suggests that lower taxes, not higher spending, were not
the source of the budget defi cits in the 1980s.
Economists continue to debate the extent to which fi scal policy can infl uence
the economy. Two factors have limited the eff ectiveness of fi scal policy. First,
fi scal policies often cannot be implemented quickly enough to have the intended
impact on the business cycle—the normal expansion and contraction of the
economy. This is especially true when one party controls Congress and the other
controls the presidency, but it happens even during unifi ed government. The $787
billion American Recovery and Reinvestment Act of 2009, designed to stimulate
the economy and create jobs, encountered problems along these lines. Although
the legislation had some immediate impact on the economy, it is impossible to
spend that much money (or implement tax cuts) without some time lag. Republi-
cans criticized Democrats for spending too much money and not enacting policies
that would have had a more immediate eff ect (such as payroll tax cuts), and other
critics argued that the stimulus wasn’t big enough.
Second, on the other side of the Keynesian coin, increasing taxes or cutting
spending during good economic times is much more diffi cult to implement than
the more politically popular tax cuts or spending increases. After all, politicians
do not like to raise taxes or cut spending. Furthermore, even if politicians wanted
to cut spending, this aspect of fiscal policy is becoming increasingly difficult
to use because a growing portion of the federal budget is devoted to mandatory
spending—that is, entitlements such as Social Security, which must be spent
by law, and interest on the federal debt, which must be paid (if the United States
defaulted on its debt, there would be an international economic meltdown). So
reducing the federal defi cit by cutting spending is increasingly diffi cult. With the
2013 defi cit running close to $900 billion, Congress would have to eliminate nearly
all discretionary spending—spending that can be cut from the budget without
changing the underlying law—including defense spending and everything else the
government does, to balance the budget.^14 (See Figure 14.4.)
Fiscal policy may have a relatively modest impact on the economy, but it
determines how the tax burden is distributed and which parts of the economy
and policy areas benefi t from federal spending. In other words, fi scal policy has
redistributive implications. There are two ways of thinking about the charac-
teristics of federal taxes: (1) the diff erent types of taxes and (2) their redistribu-
tive nature—that is, whether a specifi c tax is regressive, neutral, or progressive
(de fi ned later in the chapter). There are four major types of federal taxes: per-
sonal income taxes, corporate taxes, payroll taxes (for Social Security and Medi-
care), and excise taxes (such as taxes on cigarettes, alcohol, gasoline, air travel,

supply-side economics The

theory that lower tax rates will stim-

ulate the economy by encouraging

people to save, invest, and produce

more goods and services.

business cycle The normal pat-

tern of expansion and contraction of

the economy.

mandatory spending Expendi-

tures that are required by law, such

as the funding for Social Security.

gross domestic product The

value of a country’s economic output

taken as a whole.

discretionary spending Expen-

ditures that can be cut from the

budget without changing the under-

lying law.