Macroeconomics: Fiscal Policy,

Spending

Tools for Managing the Economy

Again, fiscal policy is managing U.S. government spending and taxing to affect the macro-economy. Fiscal policy is the primary tool of Keynesian economics, the dominant macroeconomic paradigm. Fiscal policy is used to change aggregate demand and investment.

Control of the tools is not in the hands of any single policy actor. Rather, economic policy making tends to be decentralized, lacking coordination. The president has more control over fiscal and regulatory policy than any other actor. However, the president is not free to work his will on the system.

SpendingSome U.S. fiscal policy conducted through spending operates

automatically to stabilize and promote growth in the U.S. economy. Unemployment, welfare spending, the progressive income tax.

Other fiscal policy through spending is discretionary. “Discretionary” is, however, somewhat of a misnomer. For the vast amount of public expenditures and taxation, political actors have little discretion over whether to spend money or not. Political actors tend to systematically manipulate the economy in their own self-interest. Political actors tend to focus on the short term, rather than plan macro-economic policy for the long term. They suffer from limited rationality in that they often fail to forecast the effects of changes in spending and taxing. Moreover, the effects of fiscal policy depend in no small part on the conduct of monetary and regulatory policy.

Nevertheless, there is an apparatus at the national level intended to rationally affect the macro-economy. 

The president is held largely responsible for macro-economic policy management. The president depends for advice on several policy actors including the Council of Economic Advisors, the Office of Management and Budget, and the Treasury Department.

President’s Council of Economic Advisers- The three members of the CEA and their staff are responsible for analysis, forecasting, and estimating the impact of taxing and spending changes on the economy. They are an advisory body. The CEA serves entirely at the pleasure of the president, who may appoint these members based on political preferences. Provides advice only; knowledge is power. See http://www.whitehouse.gov/administration/eop/cea.

Office of Management and Budget-OMB is responsible for formulating taxing and spending plans for the U.S. government. It may assure that spending plans are consistent with the president’s program. At any one time the OMB is formulating the next budget, helping to execute the current budget, and auditing the last budget to assure that the moneys have been spent efficiently and in accordance with the law. OMB is a large federal bureaucracy that interacts with other bureaucracies and the White House. Established in 1921 as the Bureau of the Budget; reformed and renamed in 1970. http://www.whitehouse.gov/omb

Department of Treasury- Supervises revenue collection and provides estimates of anticipated revenue to the president and CEA. One of the original Cabinet Departments. http://www.treasury.gov/Pages/default.aspx

National Economic Council- Coordinates domestic and international economic policy. Established in 1993. See http://www.whitehouse.gov/administration/eop/nec

How Does Fiscal Policy Work?Again, fiscal policy is involved with the activities of

government that affect income, consumption, investment, taxation, government spending, deficits, debt, saving, investment, exports, and imports.

Government Spending. Government expenditures include money for bureaucratic salaries, equipment, technology, welfare, social security, unemployment benefits, space exploration, health care, etc. It also includes military expenditures.

Total Federal Expenditures through time.

National Defense

Non-Defense Expenditures

Welfare and Social Services

Note that the amount of discretionary spending is limited.

Where does all the money go?

Where does the discretionary money go?

Spending or Taxes?There are questions concerning whether it is better for

the economy for government to stimulate the economy through reduced taxation or increased spending. Implicit in a tax reduction is that individuals spend money, while implicit in expenditures is that government spends it.

This is more than a partisan issue that is debated by Republicans who favor “no new taxes” versus Democrats who prefer some government expenditures for collective goods at a cost of larger government.

Consider tax reduction as a means to economic recovery, as with the 1981 and 1986 Reagan tax cuts or 2001 and 2003 Bush tax cuts. From our income flow diagram, a tax cut puts more money in the income stream for consumers. Consumers have a choice about what to do with this income. It is easy to see that they can 1) save it, 2) spend it on foreign imports, or 3) consume goods in the domestic market. If the goal is to prime the domestic pump in an economic contraction, then there is no certainty that consumers will spend their additional money in a compatible fashion, funneling their income into either savings or imports. Thus, the consensus is that both the Reagan and Bush tax cuts directed toward the wealthy did not have their intended effects.

Consider the effects of expenditures. Expenditures also add to the income stream for consumers. Generally government spending is targeted at specific sectors of the economy, such as the poor or the middle class, as with the Kennedy tax cut finally implemented in 1964 or as with the Bush tax rebates in 2008 to combat the Great Recession. High income groups got nothing, everyone else got something.

Other examples, the depression era programs spent money on public works and employment programs such as the WPA and CCC. Spending programs in the 60s and 70s went toward employment training and fostering jobs.

Government spending is likely to be more compatible with the nation’s goals in a recession since it can be targeted toward redistribution toward those most hurt by a recession, the unemployed and the poor.

Thus, tax cuts may be less efficient than expenditures when fighting a recession.

The empirical evidence on the effects of taxation is mixed.

The Kennedy tax cut finally implemented after his assassination in 1964 sparked a decade long expansion.

Clinton and the Democrats increased taxes on the highest income groups in 1993, yet economic growth was significantly higher than during the Reagan and Bush II years.

The Reagan and Bush II tax cuts targeted toward the wealthy were ineffective in stimulating robust investment and economic growth in the 1980s and 2000s.

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Real Annual Economic Growth by Presidency

Taxes, Spending, Debt, and Interest Rates

There is also a catch to using either tax cuts or expenditures in a counter-cyclical fashion, and that is the effect on the deficit and debt. Again, if taxes are too low or expenditures too high, then government must finance the difference through other means. The only way to do this is through increased deficits and debt.

However, when government finances a deficit it must borrow money to do so. It effectively moves into the investment stream and competes with the private sector for borrowing money. This increases interest rates.

Theoretically, higher interest rates can have two negative effects beyond being a tax on people’s income: 1) higher interest rates increase savings, which removes money from the income stream (potentially offsetting the advantage of reduced taxes or government spending), 2) they may also reduce investment since higher interest rates due to government competition for money makes it more difficult for private investors to borrow money.

Partisan Differences in Macroeconomic Policy

EffectivenessThere do appear to be partisan differences to

how well fiscal policy is conducted between Republican and Democratic administrations. The preceding bar chart suggests an economic advantage to having a Democrat in the White House.

Let’s flesh this out more thoroughly.

Data From Business Cycle Dating Committee, National Bureau of Economic Research

President Partisanship Start Date End DateDuration In Months

Truman Democrat February 1945(I) October 1945 (IV) 9Truman Democrat November 1948(IV) October 1949 (IV) 12Eisenhower Republican July 1953(II) May 1954 (II) 11Eisenhower Repubican August 1957(III) April 1958 (II) 9Eisenhower Republican April 1960(II) February 1961 (I) 11Nixon Republican December 1969(IV) November 1970 (IV) 12Nixon Republican November 1973(IV) March 1975 (I) 5Carter Democrat January 1980(I) July 1980 (III) 7Reagan Republican July 1981(III) November 1982 (IV) 17GHW Bush Republican July 1990(III) March 1991(I) 9GW Bush Republican March 2001(I) November 2001 (IV) 9GW Bush Republican December 2007 (IV) June 2009 (II) 18

Average Number of Recessions Starting During: Average Duration of Recessions by PartyDemocrats 3 9.33Republicans 9 11.22

STATA Regression of Economic Growth on Presidential Party

STATA Regression of Unemployment on Presidential Party

STATA Regression of Inflation on President’s Party

Problems with Fiscal Policy as Currently Applied

Only a limited proportion of the budget is available for “priming the pump.” The nature of expenditures, the obligation process, means that the president has some control over what money is spent when. However, most taxing and spending is regularized and unavailable for manipulation of the macro-economy. 

In the short term, the limited proportion of the budget available for “priming the pump” is subject to political decision-making. That is, the president and Congress must agree on taxing and spending changes. 

Increased spending or decreased taxation can be used to either simulate consumer demand (Kennedy’s 1962 tax reduction) or investment (the unrealized purpose of Reagan’s 1981 tax cut). However, there is a built-in politician bias toward increased spending and decreased taxation. Rational control of the economy may sometimes mean decreased spending and increased taxation. Occasionally politicians do manage to increase taxes in an effort to control the economy (e.g., Johnson and the income tax surcharge). However, generally these tools of macro-economic management are not used.