AMERICAN GOVERNMENT INSTITUTIONS AND POLICIES 13TH

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CHAPTER 18
Economic Policy

LEARNING OBJECTIVES
WHAT YOU NEED TO KNOW
 How do you define deficit, national debt, and gross domestic product?
 What makes the politics of taxing and spending so difficult?
 On which programs does the federal government spend most of
its money?

WHO GOVERNS?
1 Who in the federal government can make our economy strong?
2. How do you end a recession?

TO WHAT ENDS?
1. Why does the federal government ever have a budget deficit?
2. Who was responsible for the 2007–2009 recession?

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276 Chapter 18: Economic Policy

ADDITIONAL LEARNING OUTCOMES

The purpose of this chapter is to introduce the student to the theories and substance of economic policy.
After reading and reviewing the material in this chapter, the student should be able to do each of
the following:
1. Explain the economic, substantive, and political reasons for the national debt.
2. Show how voters have contradictory attitudes regarding their own and others’
economic circumstances.
3. List and briefly explain four competing economic theories. Assess the nature and impact
of Reaganomics.
4. List the four major executive-branch agencies involved in setting economic policy and explain
the role of each.
5. Analyze federal fiscal policy in terms of the text’s four categories of policymaking politics.
6. Trace the history of federal government budgeting practices.

OVERVIEW
Three kinds of economic indicators matter to voters. These are the economic health of the nation, the
amount and kinds of government spending, and the level and distribution of taxes. Different kinds of
politics influence policies for each of these outcomes.
The politics of inflation, unemployment, and economic growth tends to be majoritarian. The president
is held responsible for national conditions, even though there are only imperfect economic theories to
direct clumsy government tools controlled by divided political authorities. Still, national economic
health has powerful effects on election outcomes, driven as much by people’s perceptions of national
conditions as by their worries about personal finances.
When economic ill health occurs in some industries and places but not in others, the politics of
economic health is shaped by interest-group politics. Tariff policies are a good illustration of this
politics. Firms that import foreign products or sell to foreign nations try to avoid trade restrictions,
whereas firms and unions hurt by foreign competition try to have such restrictions imposed.
The amount of government spending is only theoretically determined by the budget. In fact, the
president and Congress struggle over particular spending bills, whose amounts often reflect interest-
group and client pressures.
The general shape of federal tax legislation is determined by majoritarian politics, but the specific
provisions (especially deductions, exemptions, and exclusions) are the result of client and interest-
group politics. The Tax Reform Act of 1986 was a remarkable example of the reassertion of
majoritarian politics over client and interest-group pressures. It was made possible by policy
entrepreneurs and political incentives.

CHAPTER OUTLINE
I. INTRODUCTION—Reasons for government debt (THEME A: POLITICS AND
ECONOMICS)

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 Chapter 18: Economic Policy 277

 Deficit: Spending more than one earns

o Financed by selling government bonds to Americans and foreigners
o National debt: Total amount of all deficits
 Economic reason for debt
o Bonds are always repaid.
o People want to buy U.S. bonds because the dollar is stable and valuable.
o Interest payments must be made each year.
 In 2006, interest was about 8 percent of all federal expenditures.
 Third most expensive program (after social welfare and defense)
 Interest payments equal about 1.7 percent of GDP
 The recession that began in 2007 and continued through 2009 resulted
in business failure, increases in unemployment, and a smaller GNP—
the cost of government increases due to increased demand for
unemployment while tax revenues are reduced due to slowed
economic activity.
o Making interest payments may be more difficult as Social Security and
Medicare costs increase with an aging population.
 Substantive argument about debt
o Families borrow to buy long-lasting items, such as a home, car, or
college education.
o Government borrows money when it needs it without thought for long-
term benefit.
 Political opposition to debt
o Public is opposed to public debt, so politicians are, too.
o Offer contrasting ways to combat it
 Conservatives: Cut spending
 Liberals: Raise taxes
o People do not want cuts in spending, but they also do not want higher taxes;
political stalemate usually results.

II. The Politics of Economic Prosperity

 Disputes about economic well-being tend to produce majoritarian politics.
o Voters see connections between nation as a whole and their own situations.
 Low-income voters more likely to worry about employment and
vote Democratic.
 High-income voters more likely to worry about inflation and
vote Republican.
o Voters respond more to condition of the national economy than of their own
personal finances.
 People understand what government can and cannot be held
accountable for.
 People see economic conditions having indirect effects on them even
when they are doing well.

A. WHAT POLITICIANS TRY TO DO

 Government officials will sometimes use money to affect elections.
o Patronage
o Veterans’ benefits
o Social Security increases

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278 Chapter 18: Economic Policy

 Government will not always do whatever is economically necessary to win

an election.
o Government does not know how to produce all desirable outcomes.
o Economic pressures are often interrelated.
 Ideology plays large role in shaping policy choices.
o Democrats focus on reducing unemployment.
o Republicans focus on reducing inflation.

III. The Politics of Taxing and Spending

 Majoritarian politics is inconsistent.
o Everyone wants general prosperity.
o Large majorities want more government spending on popular programs.
 Voters want conflicting policies: Lower taxes, less debt, and new programs.
o Lower taxes means less spending or more debt.
o More spending means higher taxes or more debt.
 Key is to raise taxes on “other people.”
o “Other people” are always a minority of voters (cigarette smokers,
affluent voters).
o For example, fund new medical research with tax on cigarettes

 WHAT CAUSED THE RECESSION?

o Federal Reserve Bank lowered interest rates.
 Firms developed new methods for selling mortgages.
 The government reduced credit requirements for lower income families
so that they could put a smaller deposit on a mortgage.
 Cheap money, combined with these new “subprime” mortgage
instruments, produced a housing boom.
 In 1999, Glass-Steagall Act was repealed. Act had separated
investment from commercial banking that reduced regulation of banks.
o Investment banks began bundling mortgages together combining secure with
subprime, or less secure, mortgages and selling them as “mortgage-
backed securities.
 Stimulated home sales
 Increased book value of homes
 Homeowners borrowed against increased value of their homes.
 Homeowners used this equity to buy goods and services within the
economy that stimulated economic growth.
o Debt levels for consumers and banks increased.
 Banks continued to loan money, increasing their vulnerability to any
downturn in the value of the real estate market, which was being used
to secure the loans.
 The economic moved into a recession, in part stimulated by increasing
fuel costs. Global production costs increased for goods and services,
which led to decreased sales.
 Many homeowners caught in the economic downturn found the
estimated value of their real estate had dropped below the value of
their mortgages. Many defaulted on their loans.

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 Chapter 18: Economic Policy 279

 Banks that held these mortgages were told by federal regulators to

revalue their holdings. Investors in the banks withdrew their holdings.
Many banks and investment companies that supported them could not
afford to maintain payments on these investments, so they failed.
 Consumers’ and investors’ confidence in global economic markets
plummeted. Credit markets froze. This led to reduced economic
activity and layoffs, which spiraled into a recession.
o Government policy exacerbated this economic crisis.
 Two government-backed corporations, Fannie Mae and Freddie Mac,
owned $5 trillion in mortgages.
 They were actually owned by private investors.
 Widespread belief was that they would be backed by the
federal government.
 They had mandated that banks issue subprime mortgages to poor
people. Many of these people were forced to default on their
mortgages, which they could not afford.
 The federal government took over the bankrupt Fannie Mae and
Freddie Mac.
o Credit Froze
 Banks afraid of an economic collapse stopped lending money to
preserve their existing capital reserves.
 Industries that relied on credit to finance purchases of their product,
home builders, and automobile companies experienced drastic
reduction in sales.
 The collapse of these two market sectors rippled through the remaining
sectors of the economy, resulting in widespread reduction in
economic activity.
 Unemployment rose as firms laid off workers whom they did not need,
due to reduced production demands.
 The stock market, reflecting these economic changes, collapsed.
 U. S. Securities and Exchange Commission brought charges against
investment banks for manipulating subprime mortgages.
 2009 Congress passed Wall Street Reform and Consumer Protection
Act. This reinstituted regulations that had been removed in 1999.

IV. Economic Theories and Political Needs

 Presidents select economic advisors whose theories reflect the president’s own
economic views.
o Conservatives tend to emphasize monetarism and supply-side approaches to
economic management.
o Liberals tend to focus on Keynesianism combined with elements of a
planned economy.

A. MONETARISM
 Asserts that inflation occurs when there is too much money chasing too few
goods (Milton Friedman)
 Advocates increasing the money supply at a rate about equal to economic
growth and then letting the free market operate

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280 Chapter 18: Economic Policy

 To combat a recession, monetarist supports cuts in interest rates by the Federal

Reserve to stimulate borrowing, which in turn stimulates purchases by
consumers, coupled with expansion of business financed by lower
interest rates.

B. KEYNESIANISM
 Argues that government should create the right level of demand
 Assumes that the health of the economy depends on what fractions of their
incomes people save or spend
 When demand is too low, government should pump money into the economy
by spending more than it collects in taxes.
 When demand is too high, government should take money out of the economy
by increasing taxes or cutting expenditures.

C. PLANNING
 Asserts that the free market is too undependable to ensure economic activity
 Government should plan parts of a country’s economic activity.
 Wage-price controls (John Kenneth Galbraith)
 In 2008–2009, the federal government began to invest in failing banks. Some
planners asserted that the government should assume control of Bank of
America and Citibank in order to recover federal investments.

D. SUPPLY-SIDE TAX CUTS

 There is a need for less government interference in the market and lower taxes
(Arthur Laffer, Paul Craig Roberts).
 Lower taxes would create incentives for work and investment.
 Greater investments lead to more jobs.
 Increase in productivity will produce more tax revenue for the government.

E. DID THE FEDERAL GOVERNMENT END THE RECESSION?

 Proponents of the 2009 stimulus law argued:
o Stimulate consumer activity by giving the public money.
o Spend more money on state, local, and federal projects to create jobs.
o Pay for these programs through increased federal borrowing.
 Republicans in Congress opposed these measures.
o It would take two to three years for government projects to stimulate
the economy.
o Borrowing this money would increase the federal debt.
o Tax cuts would have the same impact by putting more money into the
hands of consumers and businesses.
o Votes on the 2009 stimulus bill reflected deep partisan division. No
Republican in the House voted to support the measure. Three
Republican senators voted in favor of the measure.

V. The Machinery of Economic Policymaking

 Fragmented policymaking; not under president’s full control

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 Chapter 18: Economic Policy 281

o Within the executive branch, numerous organizations influence

economic policy.
 Council of Economic Advisers (CEA): Members are professional
economists sympathetic to the president’s view of economics.
 Forecasts economic trends, analyzes issues
 Prepares the annual economic report that the president sends
to Congress
 Office of Management and Budget (OMB)
 Prepares estimates of amounts to be spent by federal
government agencies; negotiates department budgets
 Ensures that departments’ legislative proposals are compatible
with the president’s program
 Secretary of the Treasury reflects the point of view of the
financial community.
 Provides estimates of government’s revenues
 Represents the nation in dealings with bankers and
other nations

A. THE FED (FEDERAL RESERVE BOARD)

 Members are appointed by the president, confirmed by the Senate; serve a
nonrenewable fourteen-year term; removable for cause.
 Chair serves for four years
 Somewhat independent of both the president and Congress
 Regulates the supply and price of money
 Sets monetary policy: The effort to shape the economy by controlling the
amount of money and bank deposits and the interest rates charged for money

B. CONGRESS
 Most important part of economic policymaking machine
 Approves all taxes and almost all expenditures
 Consents to wage and price controls
 Can alter/influence Fed policy by threatening to reduce its powers
 But Congress is also internally fragmented, with numerous committees setting
economic policy
 Creates fiscal policy when it decides how high taxes should be and how much
money the government should spend
 Effects of claims by interest groups
o Supporters of free trade find it easy to sell their goods abroad.
o Supporters of tariffs find it hard to compete with foreign imports.
o NAFTA a victory for free trade, but extension to all Latin American
countries was blocked by free-trade opponents.

C. GLOBALIZATION
 Globalization refers to the growing integration of the economies and societies
of the world.
 Supporters favor globalization because it has increased income, literacy, and
standard of living of participants; products are also cheaper.
 Opponents object to globalization for a variety of reasons.
o Cheap foreign labor may undercut wages of American workers.

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282 Chapter 18: Economic Policy

o Selfish corporate interests exploit people in poor countries.

o Local cultures are undermined by global culture.

VI. Spending Money

 Majoritarian, client, or interest-group politics all result from policy debates.
 Sources of conflict are reflected in the inconsistencies in public opinion.
 Politicians have an incentive to make two kinds of appeals:
o Keep spending down and cut deficit
o Support voters’ favorite programs
 Incompatibility of these appeals is evident in the budget.

VII. The Budget (THEME B: THE BUDGET PROCESS)

 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 programs.
 Fiscal year: Time period covered by the budget, running from October 1 to September
30 of the following year.
 Federal budget in practice: Record of expenditures instead of allocation of revenue
o No federal budget before 1921
o No unified presidential budget until the 1930s
o Congressional committees continued to respond independently.
 Congressional Budget Act of 1974: Established procedures to reform past practices
o President submits budget.
o House and Senate budget committees analyze the budget with input from the
Congressional Budget Office.
o Each committee proposes to its house a budget resolution that sets a total
budget ceiling and ceilings for each of several spending areas.
o Congress is supposed to adopt these resolutions to guide its budget debates.
o Congress considers appropriations bills and sees whether they are congruent
with the budget resolution.
o Appropriations bills cannot make big changes in the budget because
approximately two-thirds of government spending is on entitlements.
o Nothing requires Congress to make cuts, but the process has made some links
between spending and revenues.
o Reagan secured large cuts in 1981 but was unsuccessful in subsequent years.

VIII. Reducing Spending

 Passage of the Gramm-Rudman Balanced Budget Act (1985) placed the first cap
on spending.
o Called for automatic cuts from 1986 to 1991, until the federal deficit
disappeared
o If there were a lack of agreement between the president and Congress on the
total spending level, there would be automatic across-the board cuts
(a sequester).
o President and Congress still found ways to increase spending.
 A new budget strategy in 1990
o Congress voted for a tax increase.
o Enacted Budget Enforcement Act that set limits on discretionary spending

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 Chapter 18: Economic Policy 283

 If Congress spends more on one discretionary program, then it must

cut spending on another discretionary program or raise taxes.
 Law expired in 2001.

IX. Levying Taxes

 Tax policy reflects blend of majoritarian and client politics.
o “What is a ‘fair’ tax law?” (majoritarian politics)
o “How much is in it for me?” (client politics)

A. THE RISE OF THE INCOME TAX

 Most revenue was derived from tariffs until ratification of the Sixteenth
Amendment (1913).
 Taxes then varied with war (when taxes were high) and peace (when taxes
were low).
 Rates were progressive: Wealthiest individuals paid at higher rate than
less affluent
o High rates for the rich were offset by many loopholes (political
compromise between Republicans and Democrats).
o Constituencies organized around loopholes.
 Tax bills before 1986 dealt more with tax loopholes (deductions) than
with rates.
 Tax Reform Act of 1986 upset old compromise by changing policy from high
rates with big deductions to low rates with smaller deductions.
 George H. W. Bush and Clinton increased tax rates but kept deductions low.
 George W. Bush had tax cut plan approved by Congress, but cuts will expire
in 2010.
 December 2010, President Obama extended Bush tax cuts for two years in
exchange for additional money for unemployment insurance.

WEB RESOURCES
The Brookings Institution—Economic Studies: http://www.brookings.edu/es/es_hp.htm
Cato Institute: http://www.cato.org
Center on Budget and Policy Priorities: http://www.cbpp.org
Congressional Budget Office (CBO): http://www.cbo.gov
Economic Policy Institute: http://www.epinet.org
Federal Reserve Board: http://www.federalreserve.gov
Internal Revenue Service (IRS): http://www.irs.gov
Library of Economics and Liberty: http://econlib.org
Nobel laureates in economics: http://nobelprize.com/nobel_prizes/economics/laureates
Office of Management and Budget (OMB): http://www.whitehouse.gov/omb
RAND Corporation: http://www.rand.org

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284 Chapter 18: Economic Policy

TreasuryDirect, Government Section: http://www.treasurydirect.gov/govt/govt.htm

U.S. Department of the Treasury: http://www.ustreas.gov

RESEARCH AND DISCUSSION TOPICS

Is inflation a problem? Older adults often reminisce about low consumer prices of days gone by, yet
higher prices today are often offset by higher incomes. Overall, the ratio between prices and income
remains relatively the same. However, this ratio can be maintained only when inflation rates are low.
When price increases begin to exceed income increases, voters put pressure on politicians to do
something about the inflation problem. Have students investigate inflation rates in other countries and
discuss what happens to the economy and the political regime when inflation rates rise dramatically.
Ask students to interview adults who experienced the double-digit inflation rates of the late 1970s to
see how it affected their opinions about economics and politics.
Is debt a problem? From time to time, concern over the national debt prompts politicians to place
spending-reduction policies on the national agenda. However, history has shown that debt levels have
fluctuated over time without causing long-term harm to the economy. Have students discuss the
political implication of the national debt by examining the following questions: What are the concerns
about long-term debt? What are the options to deficit spending? Are balanced-budget measures feasible
or wise? Are voters likely to allow the government to post surpluses, or will they demand tax
refunds instead?
Eliminate income tax? Most taxpayers do not like paying income taxes. They object not only to the
complexity of our tax laws but also to the philosophy of taxing people more when they earn more. From
time to time, politicians have considered replacing the progressive income tax with something else,
such as a flat tax or a national sales tax. Have students select an alternative tax proposal and discuss
whether it would be viable in the current economic and political system. After researching this topic,
have students identify the interest groups supporting and opposing the flat-tax or sales-tax policy.

IMPORTANT TERMS
budget A document that states tax collections, spending levels, and the allocation of
spending among purposes.
budget resolution A congressional decision that states the maximum amount of money the
government should spend.
deficit The result of when the government in one year spends more money than it
takes in from taxes.
discretionary Spending that is not required to pay for contracts, interest on the national
spending debt, or entitlement programs such as Social Security.
economic planning The belief that government plans, such as wage and price controls or the
direction of investment, can improve the economy.
entitlements A claim for government funds that cannot be changed without violating the
rights of the claimant.
fiscal policy Managing the economy by the use of tax and spending laws.
fiscal year For the federal government, October 1 to September 30.

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 Chapter 18: Economic Policy 285

globalization The growing integration of the economies and societies of the world.
gross domestic The total of all goods and services produced in the economy during a
product given year.
Keynesianism The belief the government must manage the economy by spending more
money when in a recession and cutting spending when there is inflation.
monetarism The belief that inflation occurs when too much money is chasing too
few goods.
monetary policy Managing the economy by altering the supply of money and interest rates.
national debt The total deficit from the first presidency down to the present.
sequester Automatic spending cuts.
supply-side theory The belief that lower taxes and fewer regulations will stimulate the economy.

THEME A: POLITICS AND ECONOMICS

INSTRUCTOR RESOURCES
Sandra M. Anglund. Small Business Policy and the American Creed. Westport, CT: Praeger, 2000.
Carl Boggs. The End of Politics: Corporate Power and the Decline of the Public Sphere. New York:
Guilford Press, 2000.
George J. Borjas. Heaven’s Door: Immigration Policy and the American Economy. Princeton, NJ:
Princeton University Press, 2001.
Kenneth W. Dam. The Rules of the Global Game: A New Look at U.S. International Economic
Policymaking. Chicago: University of Chicago Press, 2001.
Chris R. Edwards. Downsizing the Federal Government. Washington, D.C.: Cato Institute, 2005.
John Ehrenberg. Servants of Wealth: The Right’s Assault on Economic Justice. Lanham, MD: Rowman
& Littlefield, 2006.
Price Fishback et al. Government and the American Economy: A New History. Chicago: University of
Chicago Press, 2007.
Jeffrey A. Frankel and Peter R. Orszag, eds. American Economic Policy in the 1990s. Cambridge, MA:
MIT Press, 2002.
Norton Garfinkle. The American Dream vs. the Gospel of Wealth: The Fight for a Productive Middle-
Class Economy. New Haven, CT: Yale University Press, 2006.
Martha L. Gibson. Conflict Amid Consensus in American Trade Policy. Washington, D.C.: Georgetown
University Press, 2000.
Thomas A. Kochan. Restoring the American Dream: A Working Families’ Agenda for America.
Cambridge: MIT Press, 2005.
Nelson Lichtenstein, ed. American Capitalism: Social Thought and Political Economy in the Twentieth
Century. Philadelphia: University of Pennsylvania Press, 2006.

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286 Chapter 18: Economic Policy

Mancur Olson. The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities.
New Haven, CT: Yale University Press, 1982.
Russell D. Roberts. The Choice: A Fable of Free Trade and Protectionism. 3rd ed. Upper Saddle River,
NJ: Pearson/Prentice-Hall, 2007.
Gene B. Sperling. The Pro-growth Progressive: An Economic Strategy for Shared Prosperity. New
York: Simon & Schuster, 2005.
Constantine J. Spiliotes. Vicious Cycle: Presidential Decision Making in the American Political
Economy. College Station: Texas A&M University Press, 2002.
Maria Vidal de Haymes, Keith M. Kilty, and Elizabeth A. Segal, eds. Latino Poverty in the New
Century: Inequalities, Challenges, and Barriers. New York: Haworth Press, 2000.

SUMMARY
Presidential accountability to the voters is a central fact about the federal government’s role in the
economy. Unfortunately, the White House cannot control the economy’s progress, because external
variables (such as world trade conditions) and the proliferation of economically influential federal
agencies can frustrate the proposed fiscal game plan. Furthermore, economic forces are so
unpredictable and volatile (a specific policy can easily backfire) that the search for economic prosperity
begins to resemble a game of Russian roulette. Accordingly, partisan ideological preferences for a
specific economic theory usually shape policy directions on such matters as unemployment, inflation,
and reduction of the federal debt.
The text discusses four major theories on the management of the economy.
1. Monetarism. Monetarists such as the late 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. Monetarists hold that 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. This should, however, be the
extent of the government’s involvement in the economy.
2. Keynesianism. For Keynesians, the market will not automatically operate at a full-employment,
low-inflation levels. When people spend too little, unemployment results, and government
should pump more money into the economy by running a deficit. That is, government should
spend more than it takes in. When demand is too great, government should run a surplus. That
is, it should take more from the economy than it returns to the economy (through spending).
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. However, 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 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

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 Chapter 18: Economic Policy 287

investment and even bring in more tax revenue as economic activity expands. This theory
formed the core of Reaganomics.
Although economic forecasting and policy implementation are inexact, economists do provide
important data to government. Presidents must have economic policies that can reconcile the various
perspectives of the voters.

DISCUSSION QUESTIONS
1. Why is the president held accountable for the economy? Remember that Congress plays an
important role in setting fiscal policy and that the Federal Reserve Board is largely independent
in setting monetary policy.
2. Each of the four theories defined above has played a dominant role in United States economic
policy, though each has dominated in a distinct historical period. Under what circumstances
would you recommend implementing which theory? What are the particular strengths of each
theory? What are the particular weaknesses?
3. One of the components of Reaganomics is the theory that tax rates take away the incentive to
work: People who work more will be penalized because they are unable to keep much of what
they earn. Which populations or professions do you think would be most affected by high tax
rates? Would high taxes deter individuals within these groups from working or investing? How
has this played out in European nations that have very high tax rates? Have they suffered a loss
of economic productivity as these theorists predict?
4. Do voters base their support of economic policy on what is best for them personally or what is
best for the nation as a whole? Is it possible for politicians to convince voters to pay more taxes
for the good of the nation? Or do they have to offset the tax increase with some corresponding
benefit (such as increased financial aid for college students)?

THEME B: THE BUDGET PROCESS

INSTRUCTOR RESOURCES
Jasmine Farrier. Passing the Buck: Congress, the Budget, and Deficits. Lexington: University Press of
Kentucky, 2004.
James J. Gosling. Budgetary Politics in American Governments. 3rd ed. New York: Routledge, 2002.
Dennis S. Ippolito. Why Budgets Matter: Budget Policy and American Politics. University Park:
Pennsylvania State University Press, 2003.
Lance T. LeLoup. Parties, Rules, and the Evolution of Congressional Budgeting. Columbus: Ohio State
University Press, 2005.
Irene S. Rubin. The Politics of Public Budgeting: Getting and Spending, Borrowing and Balancing. 5th
ed. Washington, D.C.: CQ Press, 2006.
Allen Schick and Felix LoStracco. The Federal Budget: Politics, Policy, Process. Revised ed.
Washington, D.C.: Brookings Institution Press, 2000.
Aaron B. Wildavsky and Naomi Caiden. The New Politics of the Budgetary Process. 5th ed. New York:
Pearson/Longman, 2004.

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288 Chapter 18: Economic Policy

SUMMARY
The budgetary process inevitably involves choices about which specific areas should be funded and
which ones should be cut, about who stands to benefit from the shape of the budget and who will pay
for the programs. Client politics cannot be ignored, so budgetary policy must be constructed through the
collective (and frequently opposing) viewpoints of a number of federal institutions and individuals.
In the executive branch, the troika consists of:
1. The Council of Economic Advisers (CEA), which generally represents the promarket
views of professional economists. Presidents do, however, appoint ideologically
sympathetic economists.
2. The Office of Management and Budget (OMB), which is responsible for preparing a federal
budget in accordance with the president’s program. It tries to be both a nonpartisan analyst of
spending and budget patterns and an activist imposing the president’s wishes on
the bureaucracy.
3. The Secretary of the Treasury, who is generally expected to represent the finance community’s
point of view.
The Federal Reserve System, which regulates the nation’s money supply and interest rates, is
theoretically independent of both the president and Congress, because its members serve fourteen-year
terms. However, because the president appoints members, he does have some influence over the Fed.
Congress is instrumental to the budget process because it must approve all taxes and almost all
expenditures. To centralize the budget process, Congress passed a budget law in 1974 that requires
budget committees in each house to produce a budget resolution that, when adopted, imposes ceilings
on overall spending and on spending in each area (such as health and defense). These ceilings are
supposed to guide legislative committees in drawing up specific appropriations bills. President Reagan
used the process in 1981 to get Congress to vote about $36 billion in spending cuts for fiscal 1982. For
his strategy to work, it was necessary to get Congress to vote for a total package of cuts before it voted
on any individual cut.
Cutting spending is necessarily a difficult matter. About three-fourths of all federal outlays are
relatively uncontrollable, because they are tied to entitlement benefits (many of these will be discussed
in the next chapter). Congress could reduce entitlement benefits in order to boost discretionary
spending, but it would be politically risky.
Cutting taxes, by contrast, would seem to be politically very popular. However, people object less to
income taxes, which are withheld from paychecks and never seen, than to local property taxes. Further,
Americans are more concerned about balancing the budget than about cutting taxes. In the past, tax cuts
exacerbated the chronic series of deficits that the federal government ran over the last quarter of the
20th century. Consequently, when Reagan attempted to implement his supply-side economic theory in
1981, he found it quite difficult to round up the votes in Congress. He was able to do so only by adding
a large number of “sweeteners” for special-interest groups to his basic three-year, 27 percent, across-
the-board cut. Over the long run, the most important provision of this tax bill was the indexing of tax
brackets, beginning in 1985. This was intended to eliminate automatic de facto tax increases caused by
bracket creep and to force Congress to explicitly raise taxes if it wished to generate more revenue.
George H. W. Bush and Clinton also proposed tax increases, and their bills passed with very narrow
majorities. In 1997, though, taxes were cut as part of a legislative-executive compromise intended to
balance the budget.

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 Chapter 18: Economic Policy 289

Generally, however, the George H. W. Bush and Clinton administrations combined tax increases and
spending cuts to lower the deficit. In particular, the Budget Enforcement Act of 1990 imposed a cap on
discretionary (nonentitlement) spending: Money could be moved from one discretionary area to
another, but any additional spending would require increasing taxes. The tax increase and the 1990 act
had some effect in cutting the deficit, but most of the budget surplus in Clinton’s second term was the
product of Social Security taxes.
In 2001, the George W. Bush administration negotiated to secure passage of the Economic Growth and
Tax Relief Reconciliation, which is one of only three large tax cuts passed after World War II.
Democrats opposed this bill, because they wanted to use the budget surplus to finance government
programs, rather than to provide tax cuts. They did succeed in their efforts, in that the legislation
provides tax cuts only until 2010; they also secured increased levels of funding for many federal
programs. Following the terrorist attacks of 9/11, however, the issue of a budget surplus seemed moot.
Increased spending for the war on terrorism and for homeland security decreased the likelihood of a
budget surplus.

DISCUSSION QUESTIONS
1. What tools does the president have to manage the economy? Are they sufficient to do the job?
2. Compare the national budget with your personal budget. What are the problems with having
most of your budget determined in advance by fixed expenses? For example, when housing,
transportation, and food expenses consume most of your budget, what will happen if there is a
crisis of some sort? What does the government have to do when it encounters a crisis, such as
the 9/11 terrorist attacks?
3. Part of the difficulty in determining the budget is estimating how much revenue will be
received. How many different taxes does the government impose to generate revenue (for
instance, income tax, excise taxes, telecommunications tax, and so forth)? Would it help with
budget planning if the government had just one large revenue source instead of multiple taxes?
Would it be economically or politically feasible for the government to collapse all of its
revenue into a single tax? Why or why not?
4. To what extent does the public have a say in the budget process? Does public opinion
significantly affect the types of budgetary decisions that are made by government leaders? How
do pork-barrel projects and the practice of earmarking affect the overall budget?
5. What approaches will be required to restore the U.S. Triple A credit rating? What are the pros
and cons of each approach? Raising taxes will raise more revenue but will have what impact on
the economy? Cutting programs will reduce Federal expenditures but will have what impact on
the economy?

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290 Chapter 18: Economic Policy

CLASS ASSIGNMENT
Review Video: Inside Job (A FILM BY CHARLES FERGUSON
DEVELOPED BY PROFESSOR FRANK PARTNOY, THE GEORGE E. BARRETT
PROFESSOR OF LAW AND FINANCE AT THE UNIVERSITY OF SAN DIEGO
SCHOOL OF LAW)
See the teacher’s guide at the following link:
http://www.sonyclassics.com/insidejob/_pdf/InsideJob_StudyGuide.pdf

Copyright © Cengage Learning. All rights reserved.