William_T._Bianco,_David_T._Canon]_American_Polit

Tools and theories of economic policy 551

Tools and Theories of Economic Policy

Now that we know the key players in economic policy and their goals, it is time to

examine the tools those policy makers use to accomplish those goals. Policy makers

cannot pull levers and push buttons to achieve desired outcomes, nor are they immune

from external forces that can sink the economy despite their best efforts. However,

there are certain things that leaders can do to move the massive U.S. economy in the

right direction.

Fiscal Policy

Fiscal policy is the use of the government’s taxing and spending power to influence the

direction of the economy. Developed by economist John Maynard Keynes in the 1930s,

Keynesian economics argues that policy makers can soften the effects of a recession

by stimulating the economy when overall demand is low—during a recession, when

people aren’t spending as much—through tax cuts or increased government spending.

Tax cuts put more money in people’s pockets, allowing them to spend more than

they otherwise would. The government can also inject money into the economy by

purchasing various goods, such as highways or military equipment, or by issuing direct

payments to individuals, such as unemployment compensation. From this perspective,

it is acceptable to run budget deficits to increase employment and national income,

which in turn gives a short-term boost to the economy. Keynes also pointed out that if

overall demand is too high, which might result in inflation, policy makers should cool

off the economy by cutting spending or raising taxes.^37

Perhaps the best example of a Keynesian tax cut used to stimulate the economy was

the Revenue Act of 1964. The tax cut, one of the largest in the twentieth century, helped

lay the foundation for unprecedented economic expansion in the 1960s.^38

A competing theory of fiscal policy was the basis for Ronald Reagan’s tax cuts in

1981 and has been the centerpiece of economic policy for many Republicans since then.

Supply-side economics focuses on the effects of tax policy and regulations on the

labor supply (how much people work) rather than their effects on overall demand (how

much people spend). The idea is based on the relationship between the top marginal

tax rate and total tax revenue, a measure of how much people are working (as more

people work, more tax revenue is generated), as shown in the Laffer curve, named for

economist Arthur Laffer (see Figure 15.4).The basic shape of the curve is intuitive, and

the end points are noncontroversial: if the tax rate is zero, there will be no tax revenue;

if the tax rate is 100 percent, nobody will work because they won’t get to keep any of

their money, so total tax revenue at that end of the curve is also zero.^39 Laffer argued

that if tax rates are too high (to the right of the peak in the graph), people will work less

because a large percentage of their income is going to the government. In this situation,

the government should cut taxes in order to raise total government revenue—a claim

that seems counterintuitive.^40

In practice, this theory was too good to be true. When the Reagan administration

cut taxes in 1981, with the top marginal rate going from 70 to 50 percent, revenue fell

and budget deficits exploded. Supporters of the supply-side theory argued that the

problem was on the spending side of the equation rather than on the tax revenue side.

That is, deficits went up because the Democratic Congress spent too much, not because

of Reagan’s tax cuts. However, both taxes and government spending as a share of the

EXAMINE HOW FISCAL,

MONETARY, REGULATORY,

AND TRADE POLICIES

INFLUENCE THE ECONOMY

Keynesian economics

The theory that governments should

use economic policy, like taxing and

spending, to maintain stability in the

economy.

No nation has ever taxed itself into

prosperity.

—Rush Limbaugh

supply-side economics

The theory that lower tax rates

will stimulate the economy by

encouraging people to save, invest,

and produce more goods and services.

marginal tax rate

The tax rate paid on income up to

some threshold. For example, in 2018

single people paid no income tax on

their first $12,000 of income (because

of the $12,000 standard deduction).

After deductions, they paid 10 percent

on the first $9,525 of taxable income;

12 percent on income between $21,526

and $50,700; 22 percent on income

between $50,701 and $94,500; and

so on, all the way up to 37 percent on

income over $512,000.

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