Passage II

SOCIAL SCIENCE: This passage is adapted from the revised second edition of Demystifying Economics by Allen W. Smith (© 2000 by Allen W. Smith). Gross Domestic Product (GDP) is the total dollar value of all goods and services produced in a year’s time within a country’s borders.

Economists usually define fiscal policy as the deliberate use of government raises or lowers taxes, or changes its spending levels, in order to bring about a desired change in the level of total spending, and thus the performance of the economy, it is practicing fiscal policy. Fiscal policy can also be defined more generally as simple the government’s taxing and spending policies regardless of whether or not it is trying to bring about changes in the level of total spending in the economy.

The origin of fiscal policy as a tool to bring about deliberate changes in the performance of the economy dates back to 1936 when a British economist, John Maynard Keynes, published a monumental book, The General Theory of Employment, Interest, and Money. Keynesian economics theory soon became the predominant body of economic theory in the Western world. Although his theories have undergone substantial refinement and revision, much of modern Keynesian economics is still rooted in the ideas set forth by Keynes. Keynes argued that government should play an active role in maintaining the proper level of total spending in the economy in order to minimize both unemployment and inflation. He believed that, with the proper use of the government’s spending and taxing powers, the extremes of the business cycle could be avoided.

The extremes of the business cycle, which result in high unemployment or high inflation, can be very costly. During a severe recession, millions of workers become unemployed, and billions of dollars’ worth of potential production are permanently lost. In addition, prolonged periods of high inflation can have a devastating effect on both the economy and the people.

The objectives of deliberate fiscal policy are to minimize unemployment and high inflation by using the government’s taxing and spending powers to assure the correct level of total spending, and thus the proper level of Gross Domestic Product. The principal determinant of the level of the Gross Domestic Product (GDP) is the level of the total spending in the economy. If the GDP is too high, the economy will experience inflation, and if it is too low, the economy will suffer from unemployment. Therefore, in order to have a healthy economy, it is important to have the proper amount of total spending so the GDP will be neither too high nor too low.

Fiscal policy can be used to regulate the level of total spending. If total spending is too high, the government can lower its own spending and/or increase taxes so consumers will have less after-tax money to spend. If total spending is too low, the government can increase its own spending and/or reduce taxes, so consumers will have more after-tax money to spend. At least in theory, fiscal policy can be used to regulate the level of total spending, and thus the level of production. If GDP could be maintained at the appropriate level, it would be possible to avoid both high inflation and serious unemployment.

One example of successful use of fiscal policy is the long period of economic expansion during the 1960s. When President John F. Kennedy took office in 1961, the economy was suffering from a recession that had begun in 1958, Kennedy brought into his administration economic advisers who were determined to use fiscal policy to bring the economy out of the recession. The first fiscal-policy measures included increased federal spending on highways, and legislation that allowed businesses to subtract from their taxes a part of the cost of new investment in factories and machines.

When these measures proved insufficient, the President proposed a major tax cut. Although President Kennedy was assassinated before the tax cut was enacted, his successor, Lyndon Johnson, signed an $11 billion tax cut onto law in February 1964. This large tax cut, along with substantial increases in spending for the Vietnam War, fueled an economic expansion that lasted 106 consecutive months.

Fiscal policy does not have such a good track record in combating inflation, however. The problem is not that proper fiscal policies cannot successfully control inflation. The problem is the political feasibility of getting the President and Congress to support the proper fiscal policies during periods of inflation. Higher taxes and cuts in government programs are never popular with the public, and many politicians do not have the guts to do what is right for the economy because such unpopular actions might cost them votes in the next election.