CHAPTER 14 – DOMESTIC POLICY
THE GOVERNMENT SHAPES ECONOMIC POLICY WITH THREE TOOLS: The U.S.
economy is the result of specific policies that have expanded American markets and
sustained massive economic growth. The Constitution provides that Congress shall
have the power “to lay and collect Taxes… to pay the Debts and provide for the common
Defence and general Welfare… To borrow Money… To coin Money [and] regulate the
Value thereof.” These clauses of Article I, Section 8, are the constitutional sources of the
fiscal and monetary policies of the national government. The Constitution says nothing,
however, about how these powers can be used. As it works to meet the multiple goals of
economic policy, the federal government relies on a broad set of tools that has evolved
over time. Decisions about which tools to use are not simply technical; they are highly
political and reflect conflicts over whether the government should act at all and, if so,
how.
o FISCAL POLICIES: Fiscal policy includes the government’s taxing and spending
powers. Fiscal policy shapes the economy and can be used to counteract the
business cycle, which is the pattern of highs and lows that nations’ economies
experience over time. For example, during economic slowdowns the government
may decide to stimulate the economy by increasing spending, as it did during the
coronavirus pandemic, or by reducing taxes. Conversely, if the economy is
growing too fast, which might bring inflation (a consistent increase in prices), the
government might cut back on spending or raise taxes. Through fiscal policy the
government also influences the distribution of resources in the economy when it
decides what programs to spend more or less on and which groups to tax at
higher or lower rates.
TAXATION: During the 19th century, the scope of the federal government
was quite modest, and most of its revenue came from tariffs on imported
goods, and from excise taxes, which are taxes levied on specific
products, such as tobacco and alcohol. As federal activities expanded in
the 20th century, the federal government added new sources of tax
revenue, including the corporate income tax in 1909 and the individual
income tax in 1913. At first only top earners paid the individual income
tax; it became a tax that most households paid during World War II, when
the government’s revenue needs increased dramatically. With the
creation of the Social Security system in 1935, social insurance taxes
became an additional source of federal revenue. The largest share of
federal revenue today comes from the individual income tax. It accounts
for nearly half of federal revenues. At the same time, social insurance
taxes have risen as a share of federal revenues while corporate income
taxes have declined significantly. The federal tax system has several
goals, including raising revenue for government operations, achieving
some income redistribution (reducing gaps between the lowest and
highest income groups), and providing incentives for activities policy
makers deem desirable, such as investment. One of the most important
features of the individual income tax is that it is a “progressive,” or
“graduated,” tax, with the heaviest burden carried by those most able to
pay. A tax is called progressive if people with higher incomes pay a
greater share of their income in tax. A tax is regressive if people with
higher income pay a small share of their income tax. The individual
income tax is progressive because taxable income is divided into
brackets, with higher tax rates imposed on higher brackets. For example,
, in 2020, a single person pays no tax on the first $12,000 of income. Then
the next $9,875 is taxed at 10%, the next $30,250 at 12%, and so on
through the top bracket, which taxes income above $518,400 at 37%. In
contrast, the Social Security tax is regressive. In 2020, Social Security
law applied a tax of 6.2% on the first $137,700 of income for the
retirement program. This means that a person earning $137,700 pays
$8,540 and a person making $137,700 pays $8,540 and a person making
twice as much, $275,400, pays the same $8,540 at a rate of 3.1%. And a
CEO earning $5 million in income also pays the same $8,540, for a rate
of 0.17%. Over time the individual income tax and the corporate income
tax have become less progressive. Tax cuts passed under President
Reagan in the 1980s, President George W. Bush in the 2000s, and
President Trump in 2017 reduced income taxes for most individuals and
families, with the largest reductions going to the highest earners. The
2017 tax cut also lowered corporate and small business taxes
substantially. Advocates of tax cuts directed toward high earners and
businesses argue that such cuts will provide incentives for those
individuals and companies to increase their investments in the economy
and that the cuts will not harm federal revenues. Critics say such cuts will
undermine the government’s revenue-raising capacity and reduce
redistribution.
SPENDING AND BUDGETING: The federal government’s power to
spend is one of the most important tools of economic policy. Decisions
about how much to spend affect the overall health of the economy. They
also affect every aspect of American life, from the distribution of income to
the availability of different modes of transportation to the level of
education in society. Government spending is sometimes used to
counteract the effect of economic recessions, when the economy slows
down and consumers and businesses spend less. Unlike state
governments, most of which have to balance their budgets from year to
year, the federal government can run a budget deficit, which means that
government spending exceeds revenues, with the federal government
borrowing the difference by selling government bonds on which the
government pays interest. The sum of all federal government borrowing
is called the national debt. The government used deficit spending to
stimulate the economy during both the Great Recession that began in
2007 and the coronavirus pandemic of 2020. Government spending can
also incentivize certain behaviors, through subsidies and contracts.
Subsidies are government grants of cash or other valuable commodities,
such as land. During the 19th century the federal government tried to
persuade pioneers to settle the vast western lands by giving away plots of
land contingent on improvements. Today, economic sectors receiving
substantial subsidies include agriculture, energy, transportation, health,
and national defense. Contracting is also an important technique of
policy. Like any corporation, a government agency must purchase goods
and services by contract. Contracting can be used to encourage
corporations to improve themselves, to build up whole sectors of the
economy, and to promote certain desirable goals for behavior, such as
equal employment opportunity. For example, the infant airline industry of
the 1930s was nurtured by the national government’s lucrative contracts
to carry airmail. More recently, President Obama required federal
, contractors to pay a minimum wage of $10.10 per hour even though the
prevailing federal minimum wage set by Congress was (and still is) $7.25
per hour. Decisions about spending are so important that both the
president and Congress have each created institutions to assert control
over the budget process. The Office of Management and Budget (OMB)
in the Executive Office of the President is responsible for preparing the
president’s budget, which contains the president’s spending priorities and
the estimated costs of the president’s policy proposals. The president’s
budget may have little influence on the budget that Congress ultimately
adopts, but the president’s budget is viewed as the starting point for the
annual budget debate. Congress created the Congressional Budget
Office (CBO) in 1974 so that it could have reliable information about the
costs and economic impact of the policies it considers. At the same time,
it set up a budget process designed to establish spending priorities and to
consider individual expenditures in light of the entire budget. A key
element of the process is the annual budget resolution, which designates
broad targets for spending. By estimating the costs of policy proposals,
Congress hoped to control spending and reduce deficits.
o MONETARY POLICIES: Monetary policies manipulate the growth of the entire
economy by controlling the availability of money to banks. With very few
exceptions, banks in the United States are privately owned and locally operated.
Many are chartered by states, which give banks permission to make loans, hold
deposits, and make investments within that state. However, the most important
banks are members of the federal banking system.
FEDERAL RESERVE SYSTEM: Banks did not become the core of
American capitalism without intense political controversy. In 1791
Congress, led by Treasury Secretary Alexander Hamilton, established a
Bank of the United States, but it was vigorously opposed by agricultural
interests, led by Thomas Jefferson, who feared it would be dominated by
the interests of urban, industrial capitalism. The Bank of the United
States was terminated during the administration of Andrew Jackson in the
1830s, and the fear of a central, public bank lingered when, in 1913,
Congress established an institution, the Federal Reserve System, to
integrate private banks into a single national system. The Federal
Reserve System is composed of 12 Federal Reserve banks, each located
in a major commercial city. The Federal Reserve banks are not ordinary
banks; they are bankers’ banks that make loans to other banks, clear
checks, and supply the economy with currency. They also play a
regulatory role over member banks. Every national bank must be a
member of the Federal Reserve System and must follow national banking
rules. State banks and savings-and-loan associations may also join if
they accept national rules. At the top of the system if the Federal
Reserve Board – “the Fed” – comprising seven members appointed by
the president (with Senate confirmation) for 14-year terms. The chair of
the Fed is selected by the president from among the seven members for
a 4-year term. In all other concerns, however, the Fed is an independent
agency inasmuch as its members cannot be removed during their terms
except “for cause,” and the president’s executive power does not extend
to them or their policies. The major advantage that a bank gains from
being in the Federal Reserve System is that it can borrow from the
system. Borrowing enables banks to expand their loan operations
THE GOVERNMENT SHAPES ECONOMIC POLICY WITH THREE TOOLS: The U.S.
economy is the result of specific policies that have expanded American markets and
sustained massive economic growth. The Constitution provides that Congress shall
have the power “to lay and collect Taxes… to pay the Debts and provide for the common
Defence and general Welfare… To borrow Money… To coin Money [and] regulate the
Value thereof.” These clauses of Article I, Section 8, are the constitutional sources of the
fiscal and monetary policies of the national government. The Constitution says nothing,
however, about how these powers can be used. As it works to meet the multiple goals of
economic policy, the federal government relies on a broad set of tools that has evolved
over time. Decisions about which tools to use are not simply technical; they are highly
political and reflect conflicts over whether the government should act at all and, if so,
how.
o FISCAL POLICIES: Fiscal policy includes the government’s taxing and spending
powers. Fiscal policy shapes the economy and can be used to counteract the
business cycle, which is the pattern of highs and lows that nations’ economies
experience over time. For example, during economic slowdowns the government
may decide to stimulate the economy by increasing spending, as it did during the
coronavirus pandemic, or by reducing taxes. Conversely, if the economy is
growing too fast, which might bring inflation (a consistent increase in prices), the
government might cut back on spending or raise taxes. Through fiscal policy the
government also influences the distribution of resources in the economy when it
decides what programs to spend more or less on and which groups to tax at
higher or lower rates.
TAXATION: During the 19th century, the scope of the federal government
was quite modest, and most of its revenue came from tariffs on imported
goods, and from excise taxes, which are taxes levied on specific
products, such as tobacco and alcohol. As federal activities expanded in
the 20th century, the federal government added new sources of tax
revenue, including the corporate income tax in 1909 and the individual
income tax in 1913. At first only top earners paid the individual income
tax; it became a tax that most households paid during World War II, when
the government’s revenue needs increased dramatically. With the
creation of the Social Security system in 1935, social insurance taxes
became an additional source of federal revenue. The largest share of
federal revenue today comes from the individual income tax. It accounts
for nearly half of federal revenues. At the same time, social insurance
taxes have risen as a share of federal revenues while corporate income
taxes have declined significantly. The federal tax system has several
goals, including raising revenue for government operations, achieving
some income redistribution (reducing gaps between the lowest and
highest income groups), and providing incentives for activities policy
makers deem desirable, such as investment. One of the most important
features of the individual income tax is that it is a “progressive,” or
“graduated,” tax, with the heaviest burden carried by those most able to
pay. A tax is called progressive if people with higher incomes pay a
greater share of their income in tax. A tax is regressive if people with
higher income pay a small share of their income tax. The individual
income tax is progressive because taxable income is divided into
brackets, with higher tax rates imposed on higher brackets. For example,
, in 2020, a single person pays no tax on the first $12,000 of income. Then
the next $9,875 is taxed at 10%, the next $30,250 at 12%, and so on
through the top bracket, which taxes income above $518,400 at 37%. In
contrast, the Social Security tax is regressive. In 2020, Social Security
law applied a tax of 6.2% on the first $137,700 of income for the
retirement program. This means that a person earning $137,700 pays
$8,540 and a person making $137,700 pays $8,540 and a person making
twice as much, $275,400, pays the same $8,540 at a rate of 3.1%. And a
CEO earning $5 million in income also pays the same $8,540, for a rate
of 0.17%. Over time the individual income tax and the corporate income
tax have become less progressive. Tax cuts passed under President
Reagan in the 1980s, President George W. Bush in the 2000s, and
President Trump in 2017 reduced income taxes for most individuals and
families, with the largest reductions going to the highest earners. The
2017 tax cut also lowered corporate and small business taxes
substantially. Advocates of tax cuts directed toward high earners and
businesses argue that such cuts will provide incentives for those
individuals and companies to increase their investments in the economy
and that the cuts will not harm federal revenues. Critics say such cuts will
undermine the government’s revenue-raising capacity and reduce
redistribution.
SPENDING AND BUDGETING: The federal government’s power to
spend is one of the most important tools of economic policy. Decisions
about how much to spend affect the overall health of the economy. They
also affect every aspect of American life, from the distribution of income to
the availability of different modes of transportation to the level of
education in society. Government spending is sometimes used to
counteract the effect of economic recessions, when the economy slows
down and consumers and businesses spend less. Unlike state
governments, most of which have to balance their budgets from year to
year, the federal government can run a budget deficit, which means that
government spending exceeds revenues, with the federal government
borrowing the difference by selling government bonds on which the
government pays interest. The sum of all federal government borrowing
is called the national debt. The government used deficit spending to
stimulate the economy during both the Great Recession that began in
2007 and the coronavirus pandemic of 2020. Government spending can
also incentivize certain behaviors, through subsidies and contracts.
Subsidies are government grants of cash or other valuable commodities,
such as land. During the 19th century the federal government tried to
persuade pioneers to settle the vast western lands by giving away plots of
land contingent on improvements. Today, economic sectors receiving
substantial subsidies include agriculture, energy, transportation, health,
and national defense. Contracting is also an important technique of
policy. Like any corporation, a government agency must purchase goods
and services by contract. Contracting can be used to encourage
corporations to improve themselves, to build up whole sectors of the
economy, and to promote certain desirable goals for behavior, such as
equal employment opportunity. For example, the infant airline industry of
the 1930s was nurtured by the national government’s lucrative contracts
to carry airmail. More recently, President Obama required federal
, contractors to pay a minimum wage of $10.10 per hour even though the
prevailing federal minimum wage set by Congress was (and still is) $7.25
per hour. Decisions about spending are so important that both the
president and Congress have each created institutions to assert control
over the budget process. The Office of Management and Budget (OMB)
in the Executive Office of the President is responsible for preparing the
president’s budget, which contains the president’s spending priorities and
the estimated costs of the president’s policy proposals. The president’s
budget may have little influence on the budget that Congress ultimately
adopts, but the president’s budget is viewed as the starting point for the
annual budget debate. Congress created the Congressional Budget
Office (CBO) in 1974 so that it could have reliable information about the
costs and economic impact of the policies it considers. At the same time,
it set up a budget process designed to establish spending priorities and to
consider individual expenditures in light of the entire budget. A key
element of the process is the annual budget resolution, which designates
broad targets for spending. By estimating the costs of policy proposals,
Congress hoped to control spending and reduce deficits.
o MONETARY POLICIES: Monetary policies manipulate the growth of the entire
economy by controlling the availability of money to banks. With very few
exceptions, banks in the United States are privately owned and locally operated.
Many are chartered by states, which give banks permission to make loans, hold
deposits, and make investments within that state. However, the most important
banks are members of the federal banking system.
FEDERAL RESERVE SYSTEM: Banks did not become the core of
American capitalism without intense political controversy. In 1791
Congress, led by Treasury Secretary Alexander Hamilton, established a
Bank of the United States, but it was vigorously opposed by agricultural
interests, led by Thomas Jefferson, who feared it would be dominated by
the interests of urban, industrial capitalism. The Bank of the United
States was terminated during the administration of Andrew Jackson in the
1830s, and the fear of a central, public bank lingered when, in 1913,
Congress established an institution, the Federal Reserve System, to
integrate private banks into a single national system. The Federal
Reserve System is composed of 12 Federal Reserve banks, each located
in a major commercial city. The Federal Reserve banks are not ordinary
banks; they are bankers’ banks that make loans to other banks, clear
checks, and supply the economy with currency. They also play a
regulatory role over member banks. Every national bank must be a
member of the Federal Reserve System and must follow national banking
rules. State banks and savings-and-loan associations may also join if
they accept national rules. At the top of the system if the Federal
Reserve Board – “the Fed” – comprising seven members appointed by
the president (with Senate confirmation) for 14-year terms. The chair of
the Fed is selected by the president from among the seven members for
a 4-year term. In all other concerns, however, the Fed is an independent
agency inasmuch as its members cannot be removed during their terms
except “for cause,” and the president’s executive power does not extend
to them or their policies. The major advantage that a bank gains from
being in the Federal Reserve System is that it can borrow from the
system. Borrowing enables banks to expand their loan operations
