Funding Government Programs

•

Citizens of the United States authorize the government, through the Constitution and elected officials, to raise money through taxes.

•

Taxation is the primary way that the government collects money.

•

Without revenue , or income from taxes, government would not be able to provide goods and services.

Chapter 14 Section Main Menu

Taxes and the Constitution

• •

The Power to Tax Article 1, Section 8, Clause 1 of the Constitution grants Congress the power to tax.

The Sixteenth Amendment gives Congress the power to levy an income tax.

Limits on the Power to Tax The power to tax is also limited through the Constitution: 1. The purpose of the tax must be for “the common defense and general welfare.” 2. Federal taxes must be the same in every state.

3. The government may not tax exports.

Chapter 14 Section Main Menu

Tax Bases and Tax Structures

A tax base is the income, property, good, or service that is subject to a tax.

• • •

Proportional Taxes

–

A proportional tax is a tax for which the percentage of income paid in taxes remains the same for all income levels. Progressive Taxes

–

A progressive tax is a tax for which the percent of income paid in taxes increases as income increases.

Regressive Taxes

–

A regressive tax is a tax for which the percentage of income paid in taxes decreases as income increases.

Chapter 14 Section Main Menu

Characteristics of a Good Tax

•

A good tax has the following characteristics:

–

Simplicity

•

Tax laws should be simple and easily understood.

–

Economy

•

Government administrators should be able to collect taxes without spending too much time or money.

–

Certainty

•

It should be clear to the taxpayer when the tax is due, how much is due, and how it should be paid.

–

Equity

•

The tax system should be fair, so that no one bears too much or too little of the tax burden.

Chapter 14 Section Main Menu

Individual Income Taxes

•

“Pay-as-You-Earn” Taxation

–

Federal income taxes are collected throughout the course of the year as individuals earn income.

•

Tax Withholding

–

Withholding is the process by which employers take tax payments out of an employee’s pay before he or she receives it.

•

Tax Brackets

–

The federal income tax is a progressive tax. In 1998, there were five rates, each of which applied to a different range of income.

Chapter 14 Section Main Menu

Filing a Tax Return

• •

A tax return is a form on which you declare your income to the government and determine your taxable income.

Taxable income is a person’s total (or gross) income minus exemptions and deductions. Exemptions are set amounts that you subtract from your gross income for yourself, your spouse, and any dependents.

HOURS AND EARNINGS

Hours Earnings 20 200.00

TAXES AND DEDUCTIONS

Description Amount FICA Federal State City

Total Taxes

15.20

10.25

5.10

1.00

31.55

TOTAL Taxable Wages

200.00

Less Taxes

31.55

Net Pay

168.45

Deductions are variable amounts that you can subtract from your gross income.

Chapter 14 Section Main Menu

Corporate Income Taxes

•

Like an individual, a corporation must pay a federal tax on its taxable income.

•

Corporate income taxes are progressive — as a company’s profits increase so does the amount paid in taxes.

Chapter 14 Section Main Menu

• • •

Social Security, Medicare, and Unemployment Taxes

Social Security Taxes

–

This program is funded by the Federal Insurance Contributions Act (FICA) . Most of the FICA taxes you pay go to Social Security , or Old Age, Survivors, and Disability Insurance (OASDI) Medicare Taxes

–

Medicare is a national health insurance program that helps pay for health care for people over 65 and for people with certain disabilities. Medicare is also funded by FICA taxes.

Unemployment Taxes

–

Unemployment taxes are collected by both federal and state governments. Workers can collect “unemployment compensation” if they are laid off through no fault of their own and if they are actively looking for work.

Chapter 14 Section Main Menu

Other Types of Taxes

• • • •

Excise Taxes

–

An excise tax is a tax on the sale or production of a good. Federal excise taxes range from gasoline to telephone services.

Estate Taxes

–

An estate tax is a tax on the estate, or total value of the money and property, of a person who has died. Estate taxes are paid before inheritors receive their share.

Gift Taxes

–

A gift tax is a tax on the money or property that one living person gives to another.

Import Taxes

–

Taxes on imported goods are called tariffs .

Chapter 14 Section Main Menu

Mandatory and Discretionary Spending

• •

Spending Categories Mandatory spending refers to money that lawmakers are required by law to spend on certain programs or to use for interest payments on the national debt. Discretionary spending spending about which is government planners can make choices.

Chapter 14 Section Main Menu

Entitlements

An entitlement program is a social welfare program that people are “entitled” to if they meet certain eligibility requirements.

• • •

Social Security

–

Social Security is the largest category of government spending.

Medicare

–

Medicare pays for certain health benefits for people over 65 or people who have certain disabilities and diseases.

Medicaid

–

Medicaid benefits low-income families, some people with disabilities, and elderly people in nursing homes. Medicaid costs are shared by the federal and state governments.

Chapter 14 Section Main Menu

Discretionary Spending

• •

Defense Spending Spending on defense accounts for about half of the federal government’s discretionary spending.

Defense spending pays military personnel salaries, buys military equipment, and covers operating costs of military bases.

•

Other Discretionary Spending Other discretionary spending categories include:

– – – – – – – –

Education Training Environmental cleanup National parks and monuments Scientific research Land management Farm subsidies Foreign aid Chapter 14 Section Main Menu

State Budgets

• •

Operating Budgets

–

A state’s operating budget pays for day-to-day expenses. These include salaries, supplies, and maintenance of state facilities.

•

Capital Budgets

–

A state’s capital budget pays for major capital, or investment, spending. Balanced budgets

–

Some states have laws requiring balanced budgets. These laws, however, only apply to a state’s operating budget.

Chapter 14 Section Main Menu

Where Are State Taxes Spent?

• • • • • •

Education

–

State education budgets help finance public state universities and provide some aid to local governments for elementary, middle, and high schools.

Public Safety

–

State governments operate state police systems, as well as correctional facilities within a state.

Highways and Transportation

–

Building and maintaining highways is another state expense. States also pay some of the costs of waterways and airports.

Public Welfare

–

State funds support some public hospitals and clinics. States also help pay for and administer federal benefits programs.

Arts and Recreation

–

State parks and some museums and historical sites are funded by state revenues.

Administration

–

Like the federal government, state governments spend money just to keep running.

Chapter 14 Section Main Menu

State Tax Revenues

• • •

Limits to State Taxation

–

Because trade and commerce are considered national enterprises, states cannot tax imports or exports. They also cannot tax goods sent between states.

Sales Taxes

–

Sales taxes are the main source of revenue for many states. Other State Taxes

–

Different states have various other means to collect revenue, such as state income taxes, excise taxes, corporate income taxes, business taxes, and property taxes.

Chapter 14 Section Main Menu

•

Local Government Spending and Revenues

The Jobs of Local Government Local Government Revenues

• – – – –

The following is a brief list of the many functions that local governments carry out or assist in:

–

Public school systems Law enforcement Fire protection Public transportation Public facilities, such as libraries and hospitals

–

Parks and recreational facilities

–

Record keeping (birth/death certificates, wills, etc.)

• •

Property taxes are the main source of local revenue. These taxes are paid by people who own homes, apartments, buildings, or land. Local governments sometimes collect excise, sales, and income taxes as well. Some taxes, such as room and occupancy taxes, are aimed at nonresidents in order for local governments to earn additional revenue. Chapter 14 Section Main Menu

What Is Fiscal Policy?

•

The tremendous flow of cash into and out of the economy due to government spending and taxing has a large impact on the economy.

•

Fiscal policy decisions, such as how much to spend and how much to tax, are among the most important decisions the federal government makes.

Fiscal policy is the federal government’s use of taxing and spending to keep the economy stable.

Chapter 14 Section Main Menu

Fiscal Policy and the Federal Budget

•

The federal budget is a written document indicating the amount of money the government expects to receive for a certain year and authorizing the amount the government can spend that year.

•

The federal government prepares a new budget for each fiscal year . A fiscal year is a twelve-month period that is not necessarily the same as the January – December calendar year. Chapter 14 Section Main Menu

The Budget Process

•

Congress and the White House work together to develop a federal budget.

Creating the Federal Budget

Federal agencies send requests for money to the Office of Management and Budget.

The Office of Management and Budget works with the President to create a budget. In January or February, the President sends this budget to Congress.

Congress makes changes to the budget and sends this new budget to the President.

The President signs the budget into law.

The President vetoes the budget. If Congress cannot ⁄ 3 the President’s veto, Congress and the President must work together to create a new, compromise, budget.

Chapter 14 Section Main Menu

Fiscal Policy and the Economy

The total level of government spending can be changed to help increase or decrease the output of the economy.

•

Expansionary Policies Fiscal policies that try to increase output are known as expansionary policies .

•

Contractionary Policies Fiscal policies intended to decrease output are called contractionary policies .

Chapter 14 Section Main Menu

Expansionary Fiscal Policies

•

Increasing Government Spending If the federal government increases its spending or buys more goods and services, it triggers a chain of events that raise output and creates jobs.

•

Cutting Taxes When the government cuts taxes, consumers and businesses have more money to spend or invest. This increases demand and output.

Effects of Expansionary Fiscal Policy

High prices Aggregate supply Higher output, higher prices Lower output, lower prices Aggregate demand with higher government spending Original aggregate demand Low prices Low output

Total output in the economy

High output

Chapter 14 Section Main Menu

Contractionary Fiscal Policies

•

Decreasing Government Spending If the federal government spends less, or buys fewer goods and services, it triggers a chain of events that may lead to slower GDP growth.

•

Raising Taxes If the federal government increases taxes, consumers and businesses have fewer dollars to spend or save. This also slows growth of GDP. Effects of Contractionary Fiscal Policy

High prices Aggregate supply Higher output, higher prices Lower output, lower prices Original aggregate demand Low prices Aggregate demand with lower government spending Low output

Total output in the economy

High output

Chapter 14 Section Main Menu

Limits of Fiscal Policy

Difficulty of Changing Spending Levels

–

In general, significant changes in federal spending must come from the small part of the federal budget that includes discretionary spending.

Predicting the Future

–

Understanding the current state of the economy and predicting future economic performance is very difficult, and economists often disagree. This lack of agreement makes it difficult for lawmakers to know when or if to enact changes in fiscal policy.

Delayed Results

–

Even when fiscal policy changes are enacted, it takes time for the changes to take effect. Political Pressures

–

Pressures from the voters can hinder fiscal policy decisions, such as decisions to cut spending or raising taxes. Chapter 14 Section Main Menu

Coordinating Fiscal Policy

•

For fiscal policies to be effective, various branches and levels of government must plan and work together, which is sometimes difficult.

•

Federal policies need to take into account regional and state economic differences.

•

Federal fiscal policy also needs to be coordinated with the monetary policies of the Federal Reserve.

Chapter 14 Section Main Menu

Classical Economics

•

The idea that markets regulate themselves is at the heart of a school of thought known as classical economics .

•

Adam Smith, David Ricardo, and Thomas Malthus are all considered classical economists.

•

The Great Depression that began in 1929 challenged the ideas of classical economics.

Chapter 14 Section Main Menu

Keynesian Economics

•

Keynesian economics is the idea that the economy is composed of three sectors — individuals, businesses, and government — and that government actions can make up for changes in the other two.

•

Keynesian economists argue that fiscal policy can be used to fight both recession or depression and inflation.

•

Keynes believed that the government could increase spending during a recession to counteract the decrease in consumer spending.

Chapter 14 Section Main Menu

The Multiplier Effect

•

For example, if the federal government increases spending by $10 billion, there will be an initial increase in GDP of $10 billion. The businesses that sold the $10 billion in goods and services to the government will spend part of their earnings, and so on.

•

When all of the rounds of spending are added up, the government spending leads to an increase of $50 billion in GDP. The multiplier effect in fiscal policy is the idea that every dollar change in fiscal policy creates a greater than one dollar change in economic activity.

Chapter 14 Section Main Menu

Automatic Stabilizers

•

A stable economy is one in which there are no rapid changes in economic factors. Certain fiscal policy tools can be used to help ensure a stable economy.

•

An automatic stabilizer is a government tax or spending category that changes automatically in response to changes in GDP or income.

Chapter 14 Section Main Menu

Supply-Side Economics

•

Supply-side economics stresses the influence of taxation on the economy. Supply-siders believe that taxes have a strong, negative influence on output.

•

The Laffer curve shows how both high and low tax revenues can produce the same tax revenues.

Laffer Curve

High revenues Low revenues

a

0% Low taxes

b

50%

Tax rate c

100% High taxes

Chapter 14 Section Main Menu

Balancing the Budget

Budget Surpluses

•

A budget surplus occurs when revenues exceed expenditures.

Budget Deficits

•

A budget deficit occurs when expenditures exceed revenue.

A balanced budget is a budget in which revenues are equal to spending.

Chapter 14 Section Main Menu

Responding to Budget Deficits

•

Creating Money The government can pay for budget deficits by creating money. Creating money, however, increases demand for goods and services and can lead to inflation.

• •

Borrowing Money The government can also pay for budget deficits by borrowing money.

The government borrows money by selling bonds, such as United States Savings Bonds, Treasury bonds, Treasury bills, or Treasury notes . The government then pays the bondholders back at a later date.

Chapter 14 Section Main Menu

The National Debt

•

The Difference Between Deficit and Debt The deficit is amount the government owes for one fiscal year. The national debt is the total amount that the government owes.

•

Measuring the National Debt In dollar terms, the debt is extremely large: $5 trillion at the end of the twentieth century. Economists often measure the debt as a percent of GDP.

The national debt is the total amount of money the federal government owes. The national debt is owed to anyone who holds U.S. Savings Bonds or Treasury bills, bonds, or notes.

Chapter 14 Section Main Menu

Is the Debt a Problem?

• •

Problems of a National Debt To cover deficit spending the government sells bonds. Every dollar spent on a government bond is one fewer dollar that is available for businesses to borrow and invest. This encroachment on investment in the private sector is known as the crowding-out effect.

The larger the national debt, the more interest the government owes to bondholders. Dollars spent paying interest on the debt cannot be spent on anything else, such as defense, education, or health care.

•

Other Views of a National Debt Keynesian economists argue that if government borrowing and spending help the economy achieve its full productive capacity, then the national debt outweighs the costs.

Chapter 14 Section Main Menu

The Federal Reserve Act of 1913

• •

The Federal Reserve Act of 1913 The Federal Reserve System, often referred to as “the Fed,” is a group of 12 regional, independent banks.

Initially the Federal Reserve System did not work well because the actions of one regional bank would counteract the actions of another.

• •

A Stronger Fed In 1935, Congress adjusted the Federal Reserve structure so that the system could respond more effectively to crises. Today’s Fed has more centralized powers so that regional banks can work together while still representing their own concerns. Chapter 14 Section Main Menu

Structure of the Federal Reserve

• • • •

The Board of Governors

–

The Federal Reserve System is overseen by the seven-member Governors Board of of the Federal Reserve. Actions taken by the Federal Reserve are called monetary policy .

Federal Reserve Districts

–

The Federal Reserve System consists of 12 Federal Reserve Districts, with one Federal Reserve Bank per district. The Federal Reserve Banks monitor and report on economic activity in their districts.

Member Banks

–

All nationally chartered banks are required to join the Fed. Member banks contribute funds to join the system, and receive stock in and dividends from the system in return. This ownership of the system by banks, not government, gives the Fed a high degree of political independence. The Federal Open Market Committee (FOMC)

–

The FOMC , which consists of The Board of Governors and 5 of the 12 district bank presidents, makes key decisions about interest rates and the growth of the United States money supply.

Chapter 14 Section Main Menu

•

The Pyramid Structure of the Federal Reserve

About 40 percent of all United States banks belong to the Federal Reserve. These members hold about 75 percent of all bank deposits in the United States. Structure of the Federal Reserve System Chapter 14 Section Main Menu

Federal Reserve Functions

•

How does the Federal Reserve serve the federal government?

•

How does the Federal Reserve serve banks?

•

How does the Federal Reserve regulate the banking system?

•

What role does the Federal Reserve play in regulating the nation’s money supply?

Chapter 14 Section Main Menu

Serving Government

• • •

Federal Government’s Banker

–

The Fed maintains a checking account for the Treasury Department and processes payments such as social security checks and IRS refunds. Government Securities Auctions

–

The Fed serves as a financial agent for the Treasury Department and other government agencies. The Fed sells, transfers, and redeems government securities. Also, the Fed handles funds raised from selling T-bills, T-notes, and Treasury bonds. Issuing Currency

–

The district Federal Reserve Banks are responsible for issuing paper currency, while the Department of the Treasury issues coins. Chapter 14 Section Main Menu

Serving Banks

• • •

Check Clearing

–

Check clearing is the process by which banks record whose account gives up money, and whose account receives money when a customer writes a check.

Supervising Lending Practices

–

To ensure stability in the banking system, the Fed monitors bank reserves throughout the system. The Fed also protects consumers by enforcing truth-in-lending laws. Lender of Last Resort

–

In case of economic emergency, commercial banks can borrow funds from the Federal Reserve. The interest rate at which banks can borrow money from the Fed is called the discount rate .

Chapter 14 Section Main Menu

The Journey of a Check

• •

After you write a check, the recipient presents it at his or her bank. The check is then sent to a Federal Reserve Bank.

The Path of a Check Check writer

• •

The reserve bank collects the necessary funds from your bank and transfers them to the recipient’s bank.

Your processed check is returned to you by your bank.

Check writer’s bank Chapter 14 Section Main Menu Recipient Federal Reserve Bank

Regulating the Banking System

The Fed generally coordinates all banking regulatory activities.

• •

Reserves Each financial institution that holds deposits for its customers must report daily to the Fed about its reserves and activities.

The Fed uses these reserves to control how much money is in circulation at any one time.

• •

Bank Examinations The Federal Reserve examines banks periodically to ensure that each institution is obeying laws and regulations.

Examiners may also force banks to sell risky investments if their net worth, or total assets minus total liabilities, falls too low.

Chapter 14 Section Main Menu

Regulating the Money Supply

The Federal Reserve is best known for its role in regulating the money supply. The Fed monitors the levels of M1 and M2 and compares these measures of the money supply with the current demand for money.

Factors That Affect Demand for Money 1. Cash needed on hand (Cash makes transactions easier.) 2. Interest rates (Higher interest rates lead to a decrease in demand for cash.) 3. Price levels in the economy (As prices rise, so does the demand for cash.) 4. General level of income (As income rises, so does the demand for cash.)

•

Stabilizing the Economy The Fed monitors the supply of and the demand for money in an effort to keep inflation rates stable.

Chapter 14 Section Main Menu

Money Creation

• • •

How Banks Create Money Assume that you have deposited $1,000 dollars in your checking account. The bank doesn’t keep all of your money, but rather lends out some of it to businesses and other people.

The portion of your original $1,000 that the bank needs to keep on hand, or not loan out, is called the required reserve ratio (RRR) . The RRR is set by the Fed.

As the bank lends a portion of your money to businesses and consumers, they too may deposit some of it. Banks then continue to lend out portions of that money, although you still have $1,000 in your checking account. Hence, more money enters circulation. Money creation is the process by which money enters into circulation.

Chapter 14 Section Main Menu

The Money Creation Process

To determine how much money is actually created by a deposit, we use the money multiplier formula.

The money multiplier formula is calculated as 1/RRR.

Money Creation

You deposit $1,000 into your checking account.

Your $1,000 deposit minus $100 in reserves is loaned to Elaine, who gives it to Joshua.

Joshua’s $900 deposit minus $90 in reserves is loaned to another customer.

At this point, the money supply has increased by $2,710.

$100 held in reserve $900 available for loans $90 held in reserve $810 available for loans Chapter 14 Section Main Menu

Reserve Requirements

The Fed has three tools available to adjust the money supply of the nation. The first tool is adjusting the required reserve ratio.

• •

Reducing Reserve Requirements A reduction of the RRR would free up reserves for banks, allowing them to make more loans.

A RRR reduction would also increase the money multiplier. Both of these effects would lead to a substantial increase in the money supply.

• •

Increasing Reserve Requirements Even a slight increase in the RRR would require banks to hold more money in reserve, shrinking the money supply.

This method is not used often because it would cause too much disruption in the banking system.

Chapter 14 Section Main Menu

Discount Rate

The discount rate is the interest rate that banks pay to borrow money from the Fed.

• •

Reducing the Discount Rate If the Fed wants to encourage banks to loan out more of their money, it may reduce the discount rate, making it easier or cheaper for banks to borrow money if their reserves fall too low.

Reducing the discount rate causes banks to lend out more money, which leads to an increase in the money supply.

• •

Increasing the Discount Rate If the Fed wants to discourage banks from loaning out more of their money, it may make it more expensive to borrow money if their reserves fall too low.

Increasing the discount rate causes banks to lend out less money, which leads to a decrease in the money supply.

Chapter 14 Section Main Menu

Open Market Operations

• •

The most important monetary tool is open market operations . Open market operations are the buying and selling of government securities to alter the money supply.

Bond Purchases In order to increase the money supply, the Federal Reserve Bank of New York buys government securities on the open market.

The bonds are purchased with money drawn from Fed funds. When this money is deposited in the bank of the bond seller, the money supply increases.

• •

Bond Sales When the Fed sells bonds, it takes money out of the money supply.

When bond dealers buy bonds they write a check and give it to the Fed. The Fed processes the check, and the money is taken out of circulation. Chapter 14 Section Main Menu

How Monetary Policy Works

Monetarism is the belief that the money supply is the most important factor in macroeconomic performance.

•

The Money Supply and Interest Rates The market for money is like any other, and therefore the price for money — the interest rate – is high when the money supply is low and is low when the money supply is large.

• •

Interest Rates and Spending If the Fed adopts an easy money policy , it will increase the money supply. This will lower interest rates and increase spending. This causes the economy to expand. If the Fed adopts a tight money policy , it will decrease the money supply. This will push interest rates up and will decrease spending.

Chapter 14 Section Main Menu

The Problem of Timing

•

Good Timing Properly timed economic policy will minimize inflation at the peak of the business cycle and the effects of recessions in the troughs. Business Cycles and Stabilization Policy

•

Bad Timing If stabilization policy is not timed properly, it can actually make the business cycle worse.

Business cycle Business cycle with properly timed stabilization policy Business cycle with poorly timed stabilization policy

Chapter 14 Section Time

Business cycle

Time Main Menu

Policy Lags

Policy lags are problems experienced in the timing of macroeconomic policy. There are two types:

• •

Inside Lags An inside lag is a delay in implementing monetary policy.

Inside lags are caused by the time it actually takes to identify a shift in the business cycle.

•

Outside Lags Outside lags are the time it takes for monetary policy to take affect once enacted. Chapter 14 Section Main Menu

Anticipating the Business Cycle

The Federal Reserve must not only react to current trends, but also must anticipate changes in the economy.

• •

Monetary Policy and Inflation Expansionary policies enacted at the wrong time can push inflation even higher.

If the current phase of the business cycle is anticipated to be short, policymakers may choose to let the cycle fix itself. If a recession is expected to last for years, most economists will favor a more active monetary policy.

• •

How Quickly Does the Economy Self-Correct?

Economists disagree about how quickly an economy can self correct. Estimates range from two to six years. Since the economy may take quite a long time to recover on its own, there is time for policymakers to guide the economy back to stable levels of output and prices.

Chapter 14 Section Main Menu

Fiscal and Monetary Policy Tools

The federal government and the Federal Reserve both have tools to influence the nation’s economy.

Fiscal and Monetary Policy Tools

Expansionary tools Contractionary tools Fiscal policy tools

1. increasing government spending 2. cutting taxes 1. decreasing government spending 2. raising taxes

Monetary policy tools

1. open market operations: bond purchases 2. decreasing the discount rate 3. decreasing reserve requirements 1. open market operations: bond sales 2. increasing the discount rate 3. increasing reserve requirements

Chapter 14 Section Main Menu