MODULE 10: FISCAL POLICY

Economics developed as an independent discipline in the 19th Century. According to economic

theory at the time, market economies have natural ebbs and flows but always return to full
employment. Governments therefore should not intervene during economic downturns, but take
a “hands off” approach and allow markets to naturally adjust to full capacity and full
employment.

This philosophy came to be known as laissez-faire economics—a term still used today. Relying
on such economic theory, this “hands-off” or “laissez-faire” approach was a government’s
response to every economic downturn throughout the 19th Century and into the 20th Century.

So when the Great Depression broke out in 1929, President Herbert Hoover (R) maintained his
faith in the economic dogma of the time and its reliance on laissez-faire economics to bring the
country out of its latest recession. Even as the economy drifted further into ever deeper
recession, Hoover continued to hold firm to the belief that any government intervention in the
economy was not only inefficient, but detrimental.

Acting from this view, Hoover tried to counter the Great Depression with ''volunteerism', which
consisted of voluntary collaboration between the public and private sectors of the economy. A
private business for example might partner with a local government in order to provide some
modest form of public relief. But formal government spending initiatives deliberately designed to
stimulate the economy back to full employment was never an option.

The United States economy, however, did not recover. The Great Depression not only
continued, it deepened. The economic view that markets naturally and inevitably return to full
employment was proving to be flawed. Hoover was crushed by Democratic candidate Franklin
D. Roosevelt in the Presidential Election of 1932. Roosevelt, relying on the ideas of Keynes,
would inaugurate for the first time federal government intervention in the nation’s economy with
“fiscal policies” to address the economic devastation of the Great Depression.

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10.1 FISCAL POLICY

An economy’s collective output of goods and services is the sum of four types of expenditures:
(1) household consumption, (2) business spending, (3) government purchases, and (4)
purchases by persons and entities outside a country (exports). For an economy to maintain full
employment and efficiently utilize its capital stock, expenditure levels by these four groups must
sufficiently propel an economy.

But economies can get mired in situations where large

numbers of workers are unemployed and capital
resources are under-utilized. The reduction in income
causes households to cut back on spending—
especially on discretionary purchases.

This reduction in spending in turn results in less

employment demand in other sectors of the economy.
So now more firms lay off workers in response to
weakened demand. More workers become
unemployed, and household consumption further
declines.

 a high number of households cannot purchase goods and services;

 businessses close and go out of business;
 more unemployment occurs because there is now less demand for workers;
 this increases even more the number of persons unemployed;
 even more businessses close;
 even more employment occurs;
 ....
This compounding effect from an initial downturn ripples through an economy until it is “stuck”
below potential GDP with high levels of unemployment.

This was the situation Keynes observed during the Great Depression of the 1920s and 1930s.
The physical capacity of the economy to produce goods had not changed. Factories were still
standing. No flood or earthquake or other natural disaster had destroyed the capital
infrastructure. No outbreak of disease had decimated the ranks of the workforce. No key input
price, like the price of oil, had soared on world markets. But economies remained far below their
natural productive capacity (potential GDP).

To Keynes it was clear that the events of the Great Depression contradicted the traditional view
that market economies naturally and inevitably provide full employment. An economy can settle
at an output level less than potential GDP—as depicted in Figure 10.1—from inadequate
Aggregate Demand. For although production capacity remained intact in the Great Depression,
without sufficient Aggregate Demand there were no markets for producers to sell their products.

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Figure 10.1—Macro Model of economy below potential GDP

P AS

P -----------------------
AD
| |
Y Y* Y

The seminal insight of Keynes was that ultimately aggregate demand is the principal driving
force of a thriving economy. And in situations of high unemployment, overall household
spending necessarily declines to a level consistent with high levels of unemployment.

In such situations of high unemployment when domestic households are unable to lift an
economy to its potential, Keynes set out the idea that the government could intervene and take
actions that would increase Aggregate Demand. With this seminal idea a new term emerged
into the lexicon of economic literature, fiscal policy.

1. MODELING FISCAL POLICY

Fiscal policy is distinct from government spending, which is routine government spending on
roads and schools and other public spending (modeled in the Keynesian Macro model as “gp”).
Distinct from routine government spending is fiscal policy.

Fiscal policy is a set of temporary measures taken to stimulate the economy in situations of
high unemployment and a decline in real gross domestic product. This is accomplished through
three types of actions:
(1) increases in government spending,
(2) stimulus money to households, and
(3) government assistance to businesses.

(1) Fiscal Policy through an increase in government spending

As advocated by Keynes, in times of recession the immediate goal is to pump up inadequate

Aggregate Demand—the driving force of an economy. While individual markets may be doing a
perfectly good job of allocating the exchanges among many in the population, not addressing
the larger problem strains an economy and stifles prospects for future growth.

Keynes whimsically wrote in advancing his idea of fiscal policy that while it would be best for the
government to spend stimulative money on housing, roads, and other beneficial infrastructure
improvements, if government officials could not agree on how to spend the money in practical

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ways then it should spend it in impractical ways. For example, Keynes suggested building
monuments, the modern equivalent of the Egyptian pyramids.
Figure 10.2—Movement of economy to potential GDP as a result of fiscal policy through an
increase in government spending

P
AS1

P2 ------------------------------
P1-----------------------  AD2
AD1
| |
Y1 Y2 Y
Y*

The point of Keynes was that in times of economic recession it is time for public engagement
rather than quarrel over the details. When 1 out of every 5 workers is willing and able to work
but is unemployed, the economy needs a push—and the government can provide the needed
push.
Using the Keynesian Macro Model, the causal-chain of fiscal policy from an increase in
government spending is shown below and depicted d in Figure 10.2.1

Δ fp   Δ G   Δ AD 

In setting out his theory, Keynes maintained a commitment to capitalism and market economies.
He saw no role for the government to take over and manage large corporations or entire
industries.

Keynes further believed that while government should

ensure overall Aggregate Demand is sufficient for an
economy to reach full employment, this duty did not imply
the government should attempt to set prices or dictate
wages.

For Keynes, only in dire economic times when an economy

falls and settles into a quasi-permanent condition of high
unemployment should government act to expand the
economy and push output levels consistent with a return to
full employment.

1
Note as well—although not modeled—that if government spending includes expenditures on
infrastructure such as roads or dams, an ancillary economic benefit is an increase in Aggregate Supply.

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Apart from these dire situations, market economies will perform efficiently to induce levels of
investment to meet aggregate demand at a level consistent with full employment.

Figure 10.3—Movement of economy to potential GDP as a result of fiscal policy through

monetary stimulus to households

P AS1

P2 ---------------------------------
P1------------------------  AD2
AD1
| |
Y1 Y2 Y
Y*

(2) Fiscal Policy through monetary stimulus to households

A second tool of fiscal policy is direct monetary stimulus to

households. This is accomplished either through stimulus
checks to households and/or a reduction in taxes for
middle- and low-income households.

Both policies have the same intended effect—an increase

in household disposable income. The increase in
household income in turn increases Consumption, which in
turn increases Aggregate Demand. The causal-chain from
monetary stimulus to households is shown below and is
illustrated in Figure 10.3.

Δ y   Δ C   ΔAD 

In advancing the idea of monetary stimulus to households, Keynes argued for temporary deficit
spending by the government, rejecting the balanced budget approach of the times. When levels
of unemployment are high, the government loses potential revenues with balanced budgets
because the unemployed do not generate enough tax revenues. To Keynes, it seemed obvious
that by accepting short-term deficits, tax revenues in the long-run would be boosted when
workers were again fully employed and capital utilization in the economy was fully operational.

Keynes did not—as suggested in some quarters—propose cutting taxes for the
wealthy to help an economy. Tax cuts, as Keynes wrote, should only be directed to
the low- and middle-income sector as they spend more of their income. Moreover,
Keynes argued for raising taxes on the wealthy to pay for government investment and public
relief to low- and middle income households.

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(3) Fiscal Policy through government assistance to businesses

A third tool of fiscal policy is government assistance to businesses. In developing fiscal policy,
Keynes himself never proposed direct assistance to businesses, but as Keynesian fiscal policy
evolved assistance to businesses in times of economic downturns came to be accepted as
another appropriate fiscal policy tool.

One form of government assistance to businesses is direct

subsidies to companies for investment in new capital. The increase
in capital spending is designed to increase both Aggregate Demand
by higher investment spending and Aggregate Supply by increasing
the economy’s capital stock. The causal-chain from direct subsidies
for new investment is shown below.
Δ K   Δ I   ΔAD 
 Δ K   ΔAS 

The second form of government assistance to businesses is direct

government assistance—typically in the form of guaranteed low
interest loans or subsidies to help businesses both stay open as
well as to keep employees on the payroll.
The logic of this policy is that if government assistance keeps businesses open and employees
on the payroll, the economy is stimulated through an increase in household income.
Δ y   Δ C   ΔAD 

As an example of this fiscal policy, in March 2021 responding to the economic downturn from
the Covid pandemic, President Biden signed the America Rescue Plan Act. The legislation
contained a number of provisions to assist small businesses, especially restaurants.
Specifically, the Act authorized $7.25 billion for the Paycheck Protection Program that offered
forgivable loans to small businesses and other organizations hurt by the pandemic. The majority
of the loans had to be used to support payroll expenses, while the remainder could be used for
rent, utilities, personal protective equipment or certain other business expenses.

Figure 10.4—Movement of economy to potential GDP as a result of fiscal policy through

government assistance to businesses

P AS1 AS2


P2 ----------------------------
P1---------------------  AD2
AD1
| |

6
 Y1 
Y2 Y
Y*
(4) Fiscal Policy effect of Government Spending on Infrastructure

Changes to Aggregate Demand through either increased government spending or increased

investment spending on capital equipment can also increase Aggregate Supply. If fiscal policy is
used to increase government expenditures on roads, bridges, and other infrastructure, the fiscal
policy also increases Aggregate Supply. The complete causal-chain of a fiscal policy that
increases government spending on infrastructure is:

Δ fp   Δ G   Δ AD 
  Δ B   Δ AS 

This is illustrated in Figure 10.5. There is an increase in both Aggregate Demand and Aggregate
Supply from the fiscal policy increase in Government spending on infrastructure.

Figure 10.5—Effect on both Aggregate Demand and Aggregate Supply from fiscal policy that
increases Government spending on infrastructure

P
AS1  AS2

P2 -------------------------------------
AD2
P1 --------------------------- 

AD1

|  | Y
Y1 Y2
Y*

NOTE Keynes was not as explicit in calling for government fiscal policy as many writers would
assert. A complete reading of The General Theory of Employment, Interest, and Money shows
Keynes pre-occupied with the correspondence between savings and consumption and the
necessary level of interest and money liquidity to induce full employment.

Only in his Concluding Notes does Keynes make reference for necessary government action.
“Consumption is the sole end and object of all economic activity. Opportunities for employment
are necessarily limited by the extent of aggregate demand .… The outstanding faults of the
economic society in which we live are its failure to provide for full employment. …. To put the
point concretely …. the central controls necessary to ensure full employment will, of course,
involve a large extension of the traditional functions of government.”

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From these few words came the interpretation in economic circles for government intervention
with fiscal policy in times of high unemployment.
2. EXPENDITURE MULTIPLIER

A key concept underlying the rationale for Keynesian fiscal policy is the multiplier. The
multiplier is the concept that a $1 increase in spending does not simply induce a dollar-for-
dollar stimulus to an economy. Rather, a fiscal policy increase of government spending or
monetary stimulus to households has a “multiplier” effect on economic output.

That is, the infusion of each additional dollar into an economy ripples through the economy
multiple times. One person’s spending becomes another person’s income, which leads to an
additional round of spending. So the cumulative impact on output is multiple times larger than
the initial increase in spending.

The size of the multiplier depends on the marginal propensity to consume. The marginal
propensity to consume (MPC) is the proportion of additional income households spend on the
consumption of goods and services—as opposed to saving it or paying off debt. Incorporating
the MPC into the calculation of the multiplier, the formula for the multiplier becomes:
1
Multiplier =
( 1 - MPC )

To illustrate, if a household receives a stimulus check from the government of $1,000, and
spends $900 of that one time additional income, then the marginal propensity to consume for
that household is 90% or 0.9. Applying the formula above, if across an economy the MPC is
0.9, then the societal multiplier is 10.
Multiplier = [ 1 / (1- 0.9) ] = 10

That means if households across an economy receive

stimulus checks that total $10 billion, that amount multiplies
into $100 billion of additional gross domestic product in the
general economy.

The MPC, however, differs among income groups. The MPC

is substantially higher for low- and middle-income households
than for high-income households. So the multiplier effect of
fiscal policy critically depends on how monetary stimulus to
households is targeted.

To illustrate the potential effectiveness of stimulus fiscal policy

with different MPCs for different income groups, assume an
economy is in a deep recession. Further assume the MPC for
“high-income” households is 0.1; the MPC for “middle-income” households is 0.5; and the MPC
for “low-income” households is 0.8. Using the formula for the multiplier, the multipliers for each
group are:

High-income 1.1
Middle-income 2

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 Low-income 5
In this scenario, a monetary stimulus directed to high-income households has a negligible effect
on stimulating overall aggregate demand. This is because high-income earners have a multiplier
of approximately “1”. Effectively there is no multiplier effect. (This is the reason Keynes argued
against tax cuts for the wealthy.)

In contrast, a monetary stimulus directed to the middle-income group has a doubling multiplier
effect. With a multiplier of approximately “2”, each $1 of stimulus results in $2 of additional
spending. And monetary stimulus directed to low-income households has the greatest multiplier
effect. With a multiplier of approximately “5”, each $1 of stimulus to this group multiplies to $5 in
additional economic activity.

The above example begs the question: How large is the

actual MPC for the United States? Looking at the fraction
of disposable income that households spend on
consumption, the fraction of income consumed is about
96% (0.96). But does that mean that the societal MPC for
the Unites States is 0.96? No. It means that consumers
spend an average of 96¢ out of each dollar post-tax
earned income. This fraction of spending is called the
average propensity to consume (APC).

Average propensity to consume is the proportion of

expected and earned income that is spent rather than
saved or used to pay debt. In contrast, marginal
propensity to consume (MPC) is the proportion of one-
time, unexpected income that households spend.

While the APC can be measured very easily, it does not

translate easily into deducing the value of the MPC—
because MPC measures an unexpected increase in income. That type of measure is difficult to
assess with precision and involves high level econometric analysis. Best estimates currently
suggest the overall MPC in the United States ranges between 0.2 and 0.6.2

So if the multiplier theory is valid, taken literally it seems to imply that an economy can achieve
an unlimited level of growth simply by legislating more bursts of government spending and tax
cuts. What’s the catch? The catch, of course, is the assumption that the economy can produce
as much as is demanded, i.e., that supply is "infinitely elastic" and scarcity can be eliminated.

But there is a limit to the productive capacity of an economy. When individual industries and the
economy approach full capacity higher output requires higher prices and wages, so output
above the natural potential of an economy cannot be sustained. There are just so many
workers, factories, and natural resources, and a continuous artificial push of fiscal policy will
spur high rates of inflation with little growth.

2
The relatively low value of MPC is attributed to findings that households typically use a large portion of
one-time unexpected stimulus money to pay off debt.

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A short video explaining the fiscal policy multiplier can be accessed at:
https://www.youtube.com/watch?v=XmpX7M8VtCQ
A CASE STUDY
Fiscal Policy Response to the Great Recession of 2008-09

The Great Recession—which officially lasted from December 2007 to June 2009—began
with the bursting of an 8 trillion dollar housing bubble. The resulting loss of wealth led to
sharp cutbacks in consumer spending. Up until the pandemic of 2020, this was the most
dramatic employment contraction by far of any recession since the Great Depression in
the 1930s.

During the Great Recession, U.S. GDP

declined by 0.3 percent in 2008 and
another 2.8 percent in 2009. By early 2009
unemployment had risen to 11 percent.

Newly elected President Barack Obama

moved to implement a series of Fiscal
Policies initiatives to pull the country out of
its deep recession.

The American Recovery and Reinvestment Act of 2009 (ARRA) was an economic stimulus
package signed into law by President Barack Obama on February 17, 2009. It was based
on ideas promoted by John Maynard Keynes to end the Great Depression. Congress passed
ARRA based on President Obama’s plan to put $787 billion into the pockets of American families
and small business in order to boost demand and instill confidence. Among other spending ARRA
stimulated demand by providing:

$260 billion to families through tax cuts, tax credits, and unemployment benefits;
$46 billion in Government spending for transportation and mass transit projects and
another $6 billion in water projects;
$31 billion in Government spending to modernize federal buildings; and
$54 billion to help small business private investment es with tax deductions, tax credits
and loan guarantees. 

The economy responded. Within 2 years of the passage of ARRA economic growth was
averaging over 3% and unemployment was down to 6%. Most of ARRA was re-authorized
in 2010 to continue the recovery.

By 2013 the economy was registering growth of almost 4%, unemployment had fallen to
4.9 %, and the federal budget was on track to be balanced by 2018.

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 The economic recovery prompted by the discretionary fiscal policy of ARRA continued un-
abated through 2020 until the pandemic with annual economic growth averaging 3% and
unemployment levels at or below 5%.

10.2 GOVERNMENT SPENDING

Government spending is the sum of all expenditures by federal, state, and local governments. In
the Keynesian Macro Model government spending is influenced by just two factors, fiscal
spending (fp) and government spending (gp). Fiscal policy is stimulus spending by the
government to address high unemployment. In contrast, government spending (gp)
encompasses the normal everyday expenditures by governments in the provision of goods and
services to the public.

1. FEDERAL GOVERNMENT SPENDING

Federal spending in nominal dollars (that is, dollars not adjusted for inflation) was approximately
$4.1 trillion in 202. Figure 10.6 shows the five major spending categories of the federal
government.

The largest government program in the United States is Social Security. Social Security is a
program that guarantees retirement income to qualifying older Americans. It also provides
benefits to workers who become disabled and survivor benefits to family members of workers
who die.

Social security, however, is not a government expenditure. Unlike other federal spending, social
security is a “transfer program” in which money or other aid is provided by the government
without any good or service in return. Social security is supported by a dedicated tax on wages,
the Social Security portion of the payroll tax. The benefits workers receive on retirement depend
on their taxable earnings during their working years. The more one earns up to the maximum
amount subject to Social Security taxes the more received in retirement.

Figure 10.6—Major categories of Federal spending in 2022

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Federal healthcare are government expenditures, however, and include both payments for
senior citizens (Medicare) and payments for low-income Americans (Medicaid). Medicare is the
federal program that provides health care coverage (health insurance) to persons over the age
of 65 and to persons under 65 and receiving Social Security Disability Insurance (SSDI).
Medicare is funded by the payroll tax, which taxes workers to pay for the health insurance costs
of those retired and covered by Medicare.

Medicaid is the second major federal healthcare expenditure. Medicaid is funded by the federal
government and each state to assist low-income families and individuals pay for doctor visits,
hospital stays, long-term medical, custodial care costs, medical, and more. Both the federal
portion of Medicaid and state matching funds come from federal income taxes, and Medicaid
expenses are paid directly to health care providers.

National Defense comprises about 20 percent of federal spending. Although there was a slight
uptick in the 1980s, the percentage of federal spending on national defense has remained
relatively constant in recent decades. What is notable, however, is the amount of actual dollars
spent on the military by the United States compared to other countries of the world. In 2022, the
United States spent approximately $650 billion on military spending. That is greater than the
combined total military spending by China, Russia, France, the United Kingdom, Germany,
India, and Saudi Arabia.

Apart from defense spending, non-defense discretionary spending at the federal level includes
all spending that Congress appropriates on an annual basis. Such spending includes roads and
bridges; education spending; veterans benefits; housing assistance; public health programs;
foreign affairs; law enforcement such as the Federal Bureau of Investigation; natural resources
such as funding for the Environmental Protection Agency and spending on National Parks;
direct spending to agencies such as NASA and grants to support scientific research; and funds
to assist communities. The major categories of non-defense spending compared to defense
spending are shown in Figure 10.7.

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Figure 10.7—Major categories of discretionary spending at federal level in 2022

2. FEDERAL DEFICITS, THE NATIONAL DEBT, AND THE DEBT CEILING

Interest payments are a major category of federal government spending. In 2022, interest
payments were 6 percent of all federal spending. At the national level when revenues are not
sufficient to cover expenditures, the federal government borrows money to pay its bills. In
looking at the interest obligations of the federal government, it is important to distinguish the
difference between the deficit and the debt. The deficit is not the debt.

(1) Budget Deficits

Government deficit (or surplus) refers to the balance between revenues and expenditures in a
given year. When a government spends more money than it receives in taxes in a given year, it
runs a budget deficit. Conversely, when a government receives more money than it spends in
a year, it runs a budget surplus. If spending and taxes are equal, it has a balanced budget.

Today’s annual federal deficit, the

difference between outlays and revenues
in a single year, always seems dangerous
and unprecedented. But in fact, a war is
the kind of event to generate a really big
deficit. In the US, peak deficits came
during the two world wars—World War I
(17% of GDP in 1919) and World War II
(24% in 1945). It was in World War II that
the US really entered new deficit territory.
But after World War II and for the next 35
years, successive governments brought
down the deficits.

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It is only in recent decades that large deficit spending at the federal level has become the norm.
After World War II and up to 1980, the federal government typically had budget surpluses or
small budget deficits.

But then came President Reagan (R) in 1980, and large deficits began again. President Ronald
Reagan (R) and a Republican Congress embraced deficit spending to force cutbacks in social
programs. But when Congress refused to cut popular social programs such as Social Security,
for the first time after World War II deficits soared.

In the 1990s, President Bill Clinton (D) made a commitment to again balance the federal budget.
In 1998 the goal was achieved through cuts in defense spending and tax increases on high-
income earners. The federal surpluses were so large, that when President Clinton left office in
2001 the United States was on course to completely eliminate the entire national debt by 2009.

But Clinton’s successor, President G. Bush (R), repeated the 1980 policies of Ronald Reagan
and squandered the inherited surplus with massive tax cuts for high-income earners and
increases in spending to fight a war on terror and bail out the banks. Surpluses quickly became
large deficits.
President Obama (D) continued deficit spending to revive the economy in the aftermath of the
Crash of 2008. But after the economy had re-covered, in 2017 newly elected Donald Trump (R)
again invoked a policy of deficit spending with another round of tax cuts directed to high-income
earners and large corporations.
(2) National Debt

The national debt is the accumulated deficits and interest of the federal government. It is the
sum of all past deficits and surpluses. In years of deficits, the federal government borrows funds
from U.S. citizens and foreigners to cover these deficits. Interest payments are payments on the
government debt.

Interest payments on past federal government borrowing were typically 1–2% of GDP in the
1960s and 1970s, but then climbed above 3% of GDP in the 1980s and stayed there until the
late 1990s. The government was able to repay some of its past borrowing by running surpluses
from 1998 to 2001 and, with help from low interest rates, the interest payments on past federal
government borrowing had fallen back to 1.4% of GDP by 2012.

National debt is a fact of life. The US has had debt

since its inception. Records show that debts
incurred during the American Revolutionary War
amounted to $75,463,476.52 by January 1791.

Over the following 45 years, the national debt

continued to grow. Notably, the public debt actually
shrank to zero in 1835 under President Andrew
Jackson. But soon after, it quickly grew into the
millions again.

The American Civil War resulted in dramatic debt

growth. The debt was just $65 million in 1860, but
passed $1 billion in 1863 and reached $2.7 billion
following the war. The national debt grew steadily

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into the 20th Century and was roughly $22 billion as the country paid for involvement in World
War I.

The buildup to World War II brought the debt up another order of magnitude from $51 billion in
1940 to $260 billion following the war. After this period, the debt's growth closely matched the
rate of inflation until the 1980s, when it again began to increase rapidly. As a result of the
policies of Ronald Reagan (R) between 1980 and 1990, the debt more than tripled. By the end
of FY 2008, the gross national debt had reached $10.3 trillion, about 10 times its 1980 level and
today approaches $30 trillion.

(3) Debt Ceiling

The debt ceiling is imposed by Congress on the amount of debt that the US Government can
have outstanding. The debt limit is the amount that the U.S. Treasury can borrow to pay the bills
that have become due based on these prior policy decisions.

The debt limit is not a forward-looking budgeting tool. Rather, it reflects the spending and
revenue decisions debated and enacted in prior years by prior Congresses and Administrations.
Today, 97 percent of the current national debt stems from policy choices made before the Biden
Administration took office in January 2021—choices made by both parties on their own and in a
bipartisan fashion.

What happens when the U.S. government hits the debt limit?

Once the debt limit is hit, the Federal Government cannot increase the amount of outstanding
debt. Therefore, it can only draw from any cash on hand and spend its incoming revenues. The
US Treasury can also take certain “extraordinary measures” to extend how long the federal
government can continue to pay all the government’s obligations while staying below the
allowed debt ceiling limit.

When the US Treasury exhausts its cash and extraordinary measures, the Federal Government
loses all means to pay its bills and fund operations beyond its incoming revenues, which only
cover part of what is required (about 90 percent in 2022).

So if the Federal Government exhausts all available resources, it would not have enough money
coming in to make all of its payments. These payments go towards social programs that support
households, such as Social Security, Medicare, and unemployment insurance; towards
important government functions, such as national defense and transportation and healthcare:
towards salaries for soldiers and government workers..

All national government activities and payments stop.

3. STATE AND LOCAL GOVERNMENT SPENDING

Although federal government spending often gets most media attention, state and local
government spending is also substantial. At about $3.3 trillion, combined, state and local
government spending is essentially equal to spending by the Federal Government. As Figure
10.8 shows, state and local government spending has increased over the last four decades from
around 8% of GDP to about 14% today.

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Figure 10.8—State and local government total spending and spending on education

The largest state and local expenditure is education, which accounts for about one-third of total
state and local government expenditures. In fiscal year 2021 state and local governments spent
about $950 billion per year on education (including K–12 and college and university education),
compared to only $100 billion by the federal government.
But education in some states receive much larger sums of money -- up to three times more per
pupil -- than in other states. Where the money comes from differs among states as well. And
how schools choose to spend their funding varies significantly from state to state. Schools in
New York for example spend about $23,000 per pupil. Education spending in Arizona is among
the lowest in the nation, spending only about $8,000 per pupil—ranking 47th among all states.

Public welfare spending is the second largest category of state and local spending. In 2021,
local governments spent $650 billion on public welfare. Public welfare includes spending on
means-tested programs, such as Medicaid, Temporary Assistance for Needy Families,
Supplemental Security Income, and other smaller programs. 

Nationally, 91 percent of direct spending on public welfare occurred at the state level. In 37
states, local spending accounted for less than 5 percent of total direct general expenditures on
public welfare. In all 50 states, local spending accounted for less than 20 percent. However,
while administered at the state and local level, most public welfare spending is financed by
federal transfers. In 2021, nearly $450 billion (65 percent) of public welfare spending came
from federal intergovernmental grants to state and local governments. 

The rest of state and local spending goes to highways, libraries, hospitals and healthcare,
parks and recreation, police and fire protection, and government administration. Of these
expenditures, spending on health and hospitals is the largest at about 10 percent of total
expenditures. Police and prisons are about 6 percent of state and local spending, and
spending on roads and highways is about 5 percent of local government spending.

10.3 TAX SYSTEMS

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Tax systems fall into three main categories: (1) proportional, (2) regressive, and (3)
progressive.

A proportional tax system, also referred to as a flat tax system, assesses the same tax rate on
everyone regardless of income or wealth. It is intended to create neutrality in tax incidence.

As an example of a flat tax, let’s look at three individuals with three different incomes and a flat
tax rate of 10%. The first person earns an annual taxable income of $20,000. The second earns
annual taxable income of $50,000. The third person earns an annual taxable income of
$150,000.

In this example, under a proportional tax system, the first individual with an income of $20,000
pays taxes of $2,000. The second individual, the person earning $50,000, ends up paying taxes
of $5,000. While the third individual, the one making $150,000, ends up paying $15,000 dollars.
So while the higher income earner does pay more taxes, the percentage of income paid in taxes
is the same for all income levels regardless of income.

State sales taxes are typically a proportional tax. For example, in Arizona the state sales tax is
5.6% and is applied equally to all purchases regardless of a person’s income.

Under a regressive tax system low-income individuals pay a higher percentage of their
incomes in taxes compared to high-income earners. The payroll taxes that support Social
Security is effectively a regressive tax.

The payroll tax for Social Security is imposed at a rate of 12.4%. The employer and the
employee split the tax, so an employee only sees 6.2% deducted from his/her paycheck for
Social Security. On paper the payroll tax seems to be proportional tax; that is, a flat percentage
of all wages earned is taxed. But the reality is that the payroll tax is highly regressive. As of
2021 payroll taxes for Social Security only applies up to $142,800. All income earned above
$142,800 is tax-free. So millionaires and billionaires receive the benefit of a very regressive tax
system. (See the accompanying box-- Scrapping the Cap.)

Taxes assessed under a progressive system follow

an accelerating schedule. High-income earners pay
more taxes percentage-wise than low-income earners.
This type of system is based on the presumption that
the wealthy can afford to pay more and their average
propensity to consume is lower.

The federal income tax is a nominally a progressive

tax system. Its schedule of marginal tax rates imposes
a higher income tax rate on people with higher
incomes, and a lower income tax rate on people with
lower incomes. The percentage rate increases at
intervals as taxable income increases. Each dollar the
individual earns places him into a bracket or category,
resulting in a higher tax rate once the dollar amount
hits a new threshold.

2. TAX CUTS AND JOBS ACT OF 2017

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On December 22, 2017, President Trump (R) with exclusive Republican Congressional support,
enacted the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA was the biggest tax overhaul
since the Tax Reform Act of 1986. Unlike most tax reform and fiscal policy measures, which are
undertaken in times of economic duress, the TCJA was enacted at a time of economic
prosperity. The unemployment rate in 2017 was at 4 percent, a level consistent with full
employment. And capacity utilization rate was at 75 percent, a second indicator consistent with
the economy operating at its potential.

TCJA targeted tax cuts and benefits to large corporations and the very wealthy. Under TCJA the
maximum corporate income tax rate was cut to 21 percent; and the alternative minimum tax for
corporations was repealed. In addition, American multi-national corporations received a
permanent “territorial” tax rate reduction for profits made abroad.

TCJA also targeted the very wealthy for tax benefits. Tax rates for the wealthiest Americans
were significantly reduced. In addition, the threshold for paying estate taxes—a tax imposed on
the property and assets of a deceased person—was dramatically increased allowing the very
wealthy to effectively bequeath their entire estate to heirs unaffected by any tax liability.

As to tax cuts for the low- and middle-class, while overall tax rates for middle- and low-income
households were slightly reduced under TCJA, the reality for most middle- and low-income
households was in increase in their taxes through the elimination of most itemized deductions
and allowable deductions.

Scrapping the Cap

Scrap the Cap is a political moniker that calls for eliminating the income cap on
earned income subject to Social Security tax.
The FICA (Federal Insurance Contribution Act) income cap is the point at which a
worker’s income is no longer subject to the 6.2% social security tax that
everyone pays on their earnings. Under the current law, only the first $147,000
of earnings is taxed. After that, high earners no longer pay into Social Security
for the entire year.

That means the average American

worker contributes to Social Security
with every paycheck. But millionaires
and billionaires are effectively un-
taxed.

The income cap on FICA has been

around since the tax began in 1937,

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 but has not kept up with the explosive wealth inequality experienced in recent
decades.

As a result, almost $2 trillion in earnings a year are not subject to the FICA tax,
limiting the amount of revenue collected for Social Security.

In the richest country in the world, the majority of citizens live in fear that Social
Security will no longer be there when it is their turn to claim it. Unfortunately,
this fear is all too credible due to the cap on earned income subject to social
security tax.

But under most forecast models, scraping the income cap would fully fund
Social Security and ensure decades of guaranteed full benefits for today’s
workers. Under these models, if all income was subject to social security tax—in
the same manner that all income is subject to income tax—the social security
system would be solvent for generations to come.

Figure 10.9—U.S. budget deficit by year – 1981 to 2019

In the 1980s, the same tax philosophy was enacted under President Ronald Reagan (R)—
known as “supply side economics”. Supply side economics is the economic theory that argues
that reducing taxes for the wealthy and large corporations leads to an improved economy
through increased investment.

At the time of its first implementation in the 1980s, most economists argued an economy is not
improved by “supply side” economics and the policy would simply increase the national debt.
That consensus opinion proved to be accurate. As a result of “supply side” policy, the federal
deficit in the 1980s soared from an essentially balanced budget to annual deficits of $300B. And

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while federal deficits increased, the effect on economic growth and investment spending was
negligible

Supply-side economics was rejected in the 1990s under President Clinton (D), and the federal
budget was again balanced. But deficits at the federal level again exploded in the early 2000s
when George W. Bush (R) when the Republican Congress enacted a new set of “supply-side”
economic policies. Again in 2017, most economists had the view TCJA would only spur sharp
increases in federal debt without improving the economy. That proved to be the case. In the
aftermath of the TCJA, the federal deficit surged to over $1T in 2019. And while federal deficits
increased, employment levels and investment spending remained essentially unchanged.

KEY TERMS

Average propensity to consume

The proportion of expected and earned income that is spent rather than saved.

Debt ceiling
A limit imposed by Congress on the amount of debt that the U.S. Federal government can have
outstanding.

Fiscal policy 
Temporary measures taken by government to stimulate an economy when there are high levels
of unemployment and a decline in real gross domestic product.

Government deficit
The difference on an annual basis between government revenues and expenditures.

Marginal propensity to consume

The portion of extra income that consumers spend. It is the change in consumption divided by
the change in disposable personal income.

Multiplier

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The increase in real gross domestic product from a one-time stimulus of increased income to
households or increased government spending.

National debt
The accumulated deficits and interest of the United States government.

Progressive tax system

A tax system under which high-income individuals pay a higher amount of their income in taxes
compared to low-income earners.

Proportional tax system

A tax system under which all individuals pay a similar proportion of income in taxes.

Regressive tax system

A tax system under which low-income individuals pay a higher amount of their income in taxes
compared to high-income earners.

Scrap the Cap

A political moniker that calls for eliminating the income cap subject to Social Security tax.

QUESTIONS

QUESTION 1
1A. Use the Keynesian Macro Model to depict an economy in a deep recession.

1B. Use a causal chain to depict expansionary fiscal policy through government spending.

1C. Show the effect of the fiscal policy in the Keynesian Macro Model in 1A.

QUESTION 2
2A. Use a Keynesian Macro Model to depict an economy in a deep recession.

2B. Use a causal chain to depict expansionary fiscal policy through monetary stimulus to
households.

2C. Show the effect of the fiscal policy in the Keynesian Macro Model in 2A.

QUESTION 3
Assume the marginal propensity to consume for the “highest income” earners in an economy is
0.1; the marginal propensity to consume for the “middle-income” earners in an economy is 0.4;
and the marginal propensity to consume for “low-income” earners in an economy is 0.75. 

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3A. Compute the multiplier for the  high-income earners.

3B. Compute the multiplier for the  middle-income earners.

3C. Compute the multiplier for the  low-income earners.

3D. Argue, if expansionary fiscal policy is to be employed, which group should receive most of
any monetary stimulus.

QUESTION 4
4A. In 2009, the unemployment rate in the United States was 11 percent and the nation’s
capital utilization rate was at 72 percent. Use a Keynesian Macro Model to depict the U.S.
economy in 2009; include potential GDP in the Model.

4B. Set out two causal chains to depict the theorized fiscal policy of ARRA (The American
Reinvestment and Recovery Act).

4C. In 2013, the unemployment rate in the United States was 4.9% percent, the nation was
experiencing growth of 4%, and the capital capacity utilization rate was at 82 percent. Show
changes to the economy between 2010 and 2013 in the Macro Model set out in 4A.

4D. Argue whether ARRA was fiscal policy as advocated by Keynes.

QUESTION 5
5A. Define a progressive tax system; give an example of a progressive tax in the United States.

5B. Define a regressive tax system; give an example of a regressive tax in the United States.

5C. Define a proportional tax system; give an example of a proportional tax in the United
States.

QUESTION 6
6A. Use a Keynesian Macro Model to depict the U.S. economy in 2017; include potential GDP in
the Model.

6B. Set out the causal chain to depict the theorized fiscal policy of TCJA (The Tax Cuts and Jobs
Act).

In 2017, the unemployment rate in the United States was 4 percent, capital utilization was at 83
percent, and Capital Investment Expenditures were equal to $1,698,000. In 2018, the year
following TCJA, capital expenditures were $1,697,800 and the unemployment rate the capital
utilization rate remained unchanged.
6C. Argue whether TCJA was fiscal policy as advocated by Keynes.

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6D. Argue whether TCJA had a positive effect on the economy through an increase in capital
Investment.

QUESTION 7
The FICA (Federal Insurance Contribution Act) income cap is the point at which one’s income is
no longer subject to the 6.2% social security tax that persons pay on their earnings. Under the
current law, only the first $142,800 of earnings is taxed. After that, high income earners no
longer pay Social Security tax for the entire year. Presently the Nation's total personal income
approaches $14 trillion. The Congressional Budget Office reports that 80% of all income earned
is above $147,000.
7A. What is meant by the term “Scrap the Cap.”

7B. If the Cap was “scrapped” and if 12.4 % of the income earned over $142,800 were to be
taxed to fund Social Security, how much additional revenue would be generated annually for
social security?

QUESTION 8
8A. Explain the difference between government debt and government deficit.

8B. Define the term debt ceiling.

The Federal Government is anticipated to hit the “debt ceiling” in July 2023.
8C. If the debt ceiling is not raised by Congress, what ae the immediate consequences.

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