Lecture Notes – Economic Policy

Economic Policy


1. Show how voters have contradictory attitudes
regarding their own and others’ economic benefits.

2. List and briefly explain four competing
economic theories. Assess the nature and impact of

3. List the four major federal government
agencies involved in setting economic policy, and explain the role of

4. Analyze federal fiscal policy in terms of
the text’s four categories of policymaking politics.

5. Trace the history of federal government
budgeting practices up to the present day.


I. Economic health

A. Disputes about economic well-being
tend to produce majoritarian politics

1. Voters see connections between
nation as a whole and their own situations

2. Voting behavior and economic
conditions are not always correlated at national and individual

a. People understand what
government can and cannot be held accountable for

b. People see economic conditions
having indirect effects on them even when they are doing

B. What politicians try to do

1. Elected officials tempted to
take short-term view of the economy

2. Government will not always do whatever
is economically necessary to win the election

a. Government does not know how
to produce desirable outcomes

b. Attempting to cure one economic
problem often occurs at cost to another

3. Ideology plays large role in
determining policy

a. Democrats tend to want to
reduce unemployment

b. Republicans tend to want to reduce

c. Both fear inflation, Republicans

II. Economic theories and political

A. Monetarism-asserts that inflation
occurs when there is too much money chasing too few goods (Milton

1. Advocates increase in money
supply about equal to economic growth and then let free market

B . Keynesianism-government should create
right level of demand

1. Assumes that health of economy
depends on what fraction of their incomes people save or

2. When demand is too low, government
should spend more than it collects in taxes

3. When demand is too high, government
should increase taxes or cut expenditures

C. Planning-free market too undependable to
ensure economic efficiency; therefore government should plan parts
of a country’s economy

1. Wage-price controls (John
Kenneth Galbraith)

2. Industrial policy-government directs
industrial investments (Robert Reich)

D. Supply-side tax cuts-need for less
government interference and lower taxes (Arthur Laffer, Paul Craig

1. Lower taxes would create
incentives for investment

2. Greater productivity would produce
more tax revenue

E. Ideology and theory

1. People embrace an economic
theory partly because of their political beliefs

F. Reaganomics

1. Combination of monetarism,
supply-side tax cuts, and domestic budget cutting

2. Goals not consistent

a. Reduction in size of federal

b. Stimulate economic


c. Increase in military

3. Effects

a. Rate of growth of spending
slowed (but not spending itself)

b. Military spending

c. Money supply controlled-cut
inflation but allowed interest rates to rise

d. Personal income taxes cut; Social
Security taxes increased

e. Large deficits incurred,
dramatically increasing size of national debt

f. Stimulated economy-unemployment
decreased, business activity increased

III. The machinery of economic policy

A. Fragmented policy making; not under
president’s full control

B. Within the executive branch

1. Council of Economic Advisers
(CEA)-members chosen are sympathetic to president’s view of
economics and are professional economists

a. Forecasts economic trends,
analyzes issues

b. Prepares annual economicc report,
president sends to Congress

2. Office of Management and

a. Prepares estimates of amounts
to be spent by federal government agencies; negotiates
department budgets

b. Ensures that agencies’ legislative
proposals are compatible with president’s program

3. Secretary of the Treasury-reflects
point of view of financial community

a. Provides estimates of
government’s revenues

b. Represents nation with bankers and
other nations

4. The Federal Reserve Board (The

a. Members appointed by
president, confirmed by Senate; serve a nonrenewable
fourteen-year term; removable for cause

b. Somewhat independent of both
president and Congress

c. Regulates supply and price of

C. Congress most important in economic
policy making

1 . Approves all taxes and almost
all expenditures

2. Consents to wage and price

3. Can alter Fed policy by threatening to
reduce its powers

4. But also internally fragmented, with
numerous committees setting fiscal policy

D. Effects of claims by interest

1. Usually majoritarian: economic
health good for all

2. Sometimes interest group politics:
protectionism in 1980s

IV. Spending money

A . Majoritarian, client, or interest
group politics may result

B . Sources of conflict reflected in
inconsistencies in public opinion

C. Politicians have incentive to make two
kinds of appeals

1. Keep spending down and cut

2. Support favorite programs of

D . Inconsistency of these appeals evident
in budget

V. The budget

A. Earlier practices-not allocating
revenues, just recording expenditures

1. No federal budget before

2. No unified presidential budget until

3. Congressional committees continued to
respond independently

B . Congressional Budget Act of

1. Procedures

a. President submits

b. House and Senate budget committees
analyze budget, with Congressional Budget Office

c. Budget resolution sets budget

d. Congress considers appropriations

e. Congress adopts second budget
resolution that reconciles budget ceiling with total
resulting from individual appropriations bills

2. Weakness: first resolution frequently

C. Budget Reform and Policies

1. Reagan secured large cuts in
1981, but then unsuccessful

2. Passage of Gramm-Rudman Balanced
Budget Act (1985) a. Called for

(1) A target cap on the deficit
each year, leading to a balanced budget

(2) A spending plan within those

(3) If a lack of agreement on a
spending plan exists, automatic across-the board percentage
budget cuts (a sequester)

3. “Read my lips-no new taxes”: Bush in
1988 campaign

a . Lack of
presidential-congressional agreement almost produced a
sequester of close to $100 million

b. To avoid this …

(1) Increased taxes

(2) Cut in defense

(3) New budget

c. But total spending went up almost 5

4. 1993 budget bill

a. Caps appropriations in
specific areas

b. Caps discretionary

c. Peace dividend not enough even to
cover costs of inflation

d. Passed both houses of Congress
without support of a single Republican vote

C. Difficulties in reducing

1. Interest group pressure to
increase funds for programs

2. Much of budget is expenditures
representing past commitments that cannot be altered (e.g.,
contracts, Social Security benefits, national debts):
uncontrollable spending

3. Performance of economy

VI. Levying taxes

A. Tax policy reflects blend of
majoritarian and client politics

1. “What is a ‘fair’ tax law?”

a. Tax burden is kept low

(1) Americans do pay less
than citizens of most other democratic nations

b. Requires everyone to pay

(1) Americans do cheat less
than others

2. “How much is in it for me?”

a. Requires the better-off to
pay more

(1) Progressiveness is a

matter of dispute: hard to calculate

(2) Many loopholes: example of
client politics

3. Client politics (special interests)
makes tax reform difficult

a. But Tax Reform Act passed

B. The rise of the income tax

1. Most revenue derived from
tariffs until 1913 and ratification of Sixteenth

2. Taxes then varied with war (high),
peace (low)

a . High rates offset by many
loopholes: compromise

b. Constituencies organized around

3. Tax bills before 1986 dealt more with
deductions than with rates

4. 1986: low rates with smaller
deductions, upsetting the old compromise

C. The politics of tax reform

1 . Majoritarian politics
resurfaced in demand for fairness

2. Several kinds of entrepreneurs

a. Professional economists
opposing inefficiencies and inequities

b. Supply-side ideologists

c. Publicists exposing “tax

3. Success of policy entrepreneurs
requires support of key politicians possible in 1986

4. Tax politics once again majoritarian,
as in 1913


1. How does the nations economic health effect
political behavior?

2. What is the role of politicians in regard to
economic conditions and policy making?

3. Why is political ideology so influential in
economic policy?

4. Which of the four economic thories best
meets the needs of the nation? Explain and defend.

5. What was the effect of Reaganomincs on our
national economy?

6. Why did the Republican Congress “shut down”
the government in 1997?

7. How has Clinton gotten out of the budget

8. What agencies in the executive branch exist
to manipulkate the economy and the budget?

9. What is the role of Congress in economic
policy setting?

10 How has the Congressional Budget Reform Act
of 1974 changed the budget process?

11. What has been the impact of budget reform
since 1980?

12. What makes a “good tax?”


budget A document that
announces how much the government will collect in taxes and spend in
revenues and how those expenditures will be allocated among various

budget deficit A situation in
which the government spends more than it takes in, thus pumping more
money into the economy.

budget resolution A total
budget ceiling and a ceiling for each of several spending areas
submitted by the Budget Committees in the House and Senate to their
respective chambers. These resolutions serve as targets to guide the
work of each legislative committee as it decides what should be spent
in its area.

budget surplus A situation in
which the government takes in more money than it spends, thus
draining money out of the economy.

Congressional Budget Act of 1974
The law that altered the procedure by which Congress enacts
the national budget. The Congressional Budget Office was established
as a nonpartisan congressional agency. Budget committees were created
in both houses, which then submit to each house a resolution
proposing a total budget ceiling and a ceiling for each of several
spending areas. Once these resolutions are adopted, individual
appropriations are decided. Congress then adopts a second resolution
reconciling the budget ceiling with individual appropriations

Council of Economic Advisers A
group of three professional economists who give the president expert
advice on the economy. Created in 1946, it is responsible for
forecasting economic trends, analyzing economic issues, and helping
prepare the economic report the president submits each year to
Congress. Since the president selects the CEA’s membership, its
recommendations usually reflect the ideological preferences of the

economic planning A somewhat
socialistic economic theory that holds that the government should
plan at least a part of a country’s economic activity by wage and
price controls or through industrial policy.

Federal Reserve Board A
federal agency created in 1913 composed of seven “governors” who
control the Federal Reserve System. The “Fed” is independent of both
the president and Congress. Its most important function is to
regulate the supply of money and therefore its value.

fiscal policy An attempt to
use taxes and expenditures to affect the economy.

fiscal year October 1 to
September 30, the period of time for which federal government
appropriations are made and federal books are kept.

Gramm-Rudman Balanced Budget Act
A law passed in 1985 which proposed cutting the budget until
there was no longer a deficit. The deficit was to be reduced by a
specified amount each year between 1986 and 1991. If a spending plan
could not be agreed on within those targets, federal programs (with
some exemptions) would automatically be cut by a fixed percentage.
The procedure was abandoned in 1990.

industrial policy A form of
governmental planning which became popular with academics in the
1980s and which maintains that the failure of smokestack industries
to revive through market forces requires the government to direct
investments. As a result, either these industries would recover or
new industries would take their place.

Keynesianism A liberal
economic theory developed by English economist John Maynard Keynes,
who believed that economic health depends on the proportions of
income which are saved and spent. The government’s task is to create
the right level of demand. When demand is too low, the government
should pump money into the economy through spending on its programs.
When demand is too great, the government should take money out of the
economy by increasing taxes or cutting spending.

loophole politics A form of
client politics involving deductions, exemptions, and exclusions by
which people shelter some of their income from taxation.

marginal rate The percentage
of the last dollar a person earns that must be paid out in

monetarism A conservative
economic theory that holds that inflation occurs when too much money
is chasing too few goods. Since the federal government has the power
to create money, it should increase the money supply at a rate about
equal to the growth in the economy’s productivity; beyond that, it
should leave matters alone and let the free market

monetary policy An attempt to
use the amount of money and bank deposits and the price of money
(interest rate) to affect the economy.

Office of Management and
Created as the Bureau of the Budget in 1921 and made
part of the executive office in 1939, its chief functions are to
prepare estimates of the amount that will be spent by federal
agencies, to negotiate with departments on the size of their budgets,
and to make sure departmental and agency proposals are in accord with
the president’s agenda.

peace dividend Following the
collapse of the Soviet Union, the expected sums of money freed up by
cuts in post-Cold War defense spending that could be transferred to
domestic spending.

price and wage controls The
means of economic planning which reflect the belief that the
government should intervene in inflationary times by regulating the
maximum prices that can be charged and the wages that can be paid.
Such controls would be imposed only on the largest

Reaganomics The economic
program instituted by President Ronald Reagan in 1981 which combined
the theories of monetarism, supply-side tax cuts, and domestic budget
cutting. The goal was to reduce the size of the federal government,
to stimulate economic growth, and to increase American military

secretary of the treasury Head
of the Department of the Treasury nominated by the president and
confirmed by the Senate. The secretary provides estimates of the
revenue the government can expect from existing taxes and the
projected revenues from changes in tax laws. The secretary also
represents the United States in its dealings with the top bankers and
finance ministers of other nations.

sequester A provision of the
Gramm-Rudman Balanced Budget Act that requires an automatic,
across-the-board percentage cut in federal programs-except for
certain exempt programs-if the Congress and president cannot agree on
a spending plan within a specified target set for that year by the

Sixteenth Amendment A
constitutional amendment ratified in 1913 which authorized Congress
to levy an income tax. The amendment was necessary because of a
Supreme Court decision in 1895 which voided Congress’s effort to
impose such a tax.

supply-side theory A
conservative economic theory that maintains that sharp tax cuts
increase the incentive for people to work, save, and invest. The
greater productivity of the economy stimulated by these increased
investments would produce more revenue for the government despite the
tax cut.

tariff A tax on goods imported
into a country.

tax expenditures A term used
by policy entrepreneurs denouncing tax loopholes as subsidies to
groups that have not been made as appropriations through the normal
annual congressional process.

Tax Reform Act of 1986 A law
that effected a major change in tax policy resulting from the
resurfacing of majoritarian politics that demanded fairness. Instead
of high rates with big deductions, the law substituted low rates with
much smaller deductions.

uncontrollable spending Budget
outlays that are already committed and cannot be altered for either
legal or political reasons. This spending includes contracts,
payments to individuals guaranteed by law, and interest on the
national debt. About three-fourths of governmental expenditures fall
into this category.

Four major theories on the management
of the economy are discussed in the text.

1. Monetarism. Monetarists such as
Milton Friedman hold that inflation is the result of too much money
chasing too few goods. This occurs when government prints too much
money. When government tries to stop inflation by decreasing the
money supply, unemployment increases. Rather than adopting these
start-and-stop policies, it would be better if government allowed the
money supply to increase steadily and consistently at a rate about
equal to the growth in the productivity of the economy.

2. Keynesianism. For Keynesians, the
market will not automatically operate at a full-employment,
low-inflation level. When people spend too little, unemployment
results, and government should pump more money into the economy by
running a deficit (that is, by spending more than it takes in). When
demand is too great, government should run a surplus. Thus an
activist government fiscal policy is necessary.

3. Planning (price and wage controls,
industrial policy).
Economists such as John Kenneth Galbraith
feel that large institutions in the economy (corporations and labor
unions) have the ability to escape competitive pressures and raise
prices, whatever the money supply or level of consumer demand. Thus
the government must control wages and prices. But with the curbing of
inflation in the 1980s and the voluntary lowering of wages and
prices, a different type of planning by government was considered.
Industrial policy reflected the federal government’s desire to direct
investment to declining but vital smokestack industries-steel and
auto-in imitation of the Japanese model. This model was endorsed by
Robert Reich.

4. Supply-side tax cuts. This
relatively new theory, propounded by people such as Arthur Laffer and
Paul Craig Roberts, holds that high taxes create inflation and
economic stagnation by removing people’s incentive to work. Thus
cutting tax rates will encourage work and investment and even bring
in more tax revenue as economic activity expands.
This theory forms the core of Reaganomics.