Democrats & Liberals Archives

Choosing Sides: Fiscal Policy 101

One of the most talked about, and perhaps most influential issues in any election is the national economy. Income tax, capital gains tax, gross national product, budget deficit, spending cuts, unemployment rates, stock market, Dow Jones, interest rates, the Federal Reserve, and many more terms are tossed about all the time, but what do they really mean? Some of the issues that get discussed are extremely complicated, and more often than not, the complicated parts aren’t explained. There is an implicit learning curve involved, and if you don’t understand things like supply-side economics going in, it is very difficult to make heads or tails of the discussion. So here are the beginnings of a primer.

The US economy, in broad strokes, can be measured purely in terms of supply and demand. The Gross Domestic Product is a measurement of how much our economy produces. I.E. how much stuff do we make. Income and consumer spending represent the demand side of the equation. I.E. how much stuff do we buy. That is a gross oversimplification, but it is the gist of it. Now, what about the role that our government plays in all of this?

Typically there are two methods the government is able to take in economic management. Fiscal policy and monetary policy. Fiscal policy is the legislative route. Changes in the tax code, refunds, tax cuts, tax increases, government spending are all methods the government can use to effect the amount of money a given citizen has, and what he or she can do with it. Monetary policy is the domain of the Federal Reserve. The Fed handles different issues, such as how much money is present in the economy, and setting the overnight lending rate (the Discount Rate). These are more indirect mechanisms for manipulating the economy, but they have proven to be very effective.

During the Campaign
However, in an election, we as voters are only given options in the fiscal policy realm. It is a widely understood fact that our economy is currently in a state of recession, or negative growth. Right now we are on the positive side of the supply and demand equation. We have more production capability than is required to meet the demand of the economy. That is why businesses are cutting back their work force. Again, this is something of an oversimplification of things, but it is broadly accurate. Therefore, in order to stimulate the economy, our government needs to undertake a fiscal policy that will increase demand for goods and services, which will create jobs and turn things around. Stimulating investment isn't necessarily the first step on that road, so much as stimulating consumer spending is.

There are a number of fiscal philosophies out there and figuring out which ones make sense, and which don't can seem impossible at times. One of the problems with economics is that it is extremely difficult to attribute cause and effect. Nothing ever happens in a vacuum, nor is there ever only one thing going on at a time. Reagan's large tax cut in the early eighties coincided with legislation which closed a large number of tax loopholes and increased the enforcement capabilities of the Treasury. Combine that with voluminous government spending and a steady decline in the amount of money Americans were saving, and you'll see an increase in available funds. (In addition to enormous increases in our national deficit)

Supply vs Demand
Supply-side theorists will talk about the Laffer curve, which essentially says that tax revenues are a function of the tax rate, but not an arithmetic one. Given a tax rate of 0%, you will earn zero revenue. Precisely the same result occurs at a tax rate of 100%, as the taxed worker has no incentive to earn even one dollar. The tricky part is in between. Laffer's theory doesn't say what tax rate is the correct one, merely that a rate may be too high, and that lowering the rate may increase revenue, not that it will. Supply side doctrine dictates that in order to grow the economy, place more money in the hands of the investors and the business-owners, thereby stimulating them to more production, more supply.

Demand-side theorists will tell you that putting more money into the hands of people who will spend it on goods and services (or save it) will stimulate the economy, resulting in an increase in production to meet the increased demand. There are certainly some problems with this viewpoint as well. Methods of getting money into the hands of the consumers most likely to spend it are sketchy at best. Traditional methods (welfare, entitlements) are often viewed as failures by the populace. Often in a recession the less wealthy have been living on a much higher debt-burden, and will use the extra income to pay off or lower that debt, which does little to increase demand.

Some Related Reading:

Thats all for now. If you have corrections, comments, opinions or concerns, please post them here. This is an issue that is often heated, and always somewhat confusing, so make sure you provide some facts to go along with your comments. In my next post, I'll apply some of these concepts to the current crop of candidates and their proposals.

Posted by crutan at June 16, 2003 7:15 PM