An Outline of the US Economy: Monetary and Fiscal Policy

Read this chapter by Christopher Conte, a former editor and reporter for the Wall Street Journal, and Albert R. Karr, a former Wall Street Journal reporter, for a historical perspective on fiscal and monetary policy, its evolution over the years, and its current functionality.

Fiscal Policy – Budget and Taxes

The growth of government since the 1930s has been accompanied by steady increases in government spending. In 1930, the federal government accounted for just 3.3 percent of the nation's gross domestic product, or total output of goods and services excluding imports and exports. That figure rose to almost 44 percent of GDP in 1944, at the height of World War II, before falling back to 11.6 percent in 1948. But government spending generally rose as a share of GDP in subsequent years, reaching almost 24 percent in 1983 before falling back somewhat. In 1999 it stood at about 21 percent.

The development of fiscal policy is an elaborate process. Each year, the president proposes a budget, or spending plan, to Congress. Lawmakers consider the president's proposals in several steps. First, they decide on the overall level of spending and taxes. Next, they divide that overall figure into separate categories – for national defense, health and human services, and transportation, for instance. Finally, Congress considers individual appropriations bills spelling out exactly how the money in each category will be spent. Each appropriations bill ultimately must be signed by the president in order to take effect. This budget process often takes an entire session of Congress; the president presents his proposals in early February, and Congress often does not finish its work on appropriations bills until September (and sometimes even later).

The federal government's chief source of funds to cover its expenses is the income tax on individuals, which in 1999 brought in about 48 percent of total federal revenues. Payroll taxes, which finance the Social Security and Medicare programs, have become increasingly important as those programs have grown. In 1998, payroll taxes accounted for one-third of all federal revenues; employers and workers each had to pay an amount equal to 7.65 percent of their wages up to $68,400 a year. The federal government raises another 10 percent of its revenue from a tax on corporate profits, while miscellaneous other taxes account for the remainder of its income. (Local governments, in contrast, generally collect most of their tax revenues from property taxes. State governments traditionally have depended on sales and excise taxes, but state income taxes have grown more important since World War II).

The federal income tax is levied on the worldwide income of U.S. citizens and resident aliens and on certain U.S. income of non-residents. The first U.S. income tax law was enacted in 1862 to support the Civil War. The 1862 tax law also established the Office of the Commissioner of Internal Revenue to collect taxes and enforce tax laws either by seizing the property and income of non-payers or through prosecution. The commissioner's powers and authority remain much the same today.

The income tax was declared unconstitutional by the Supreme Court in 1895 because it was not apportioned among the states in conformity with the Constitution. It was not until the 16th Amendment to the Constitution was adopted in 1913 that Congress was authorized to levy an income tax without apportionment. Still, except during World War I, the income tax system remained a relatively minor source of federal revenue until the 1930s. During World War II, the modern system for managing federal income taxes was introduced, income tax rates were raised to very high levels, and the levy became the principal sources of federal revenue. Beginning in 1943, the government required employers to collect income taxes from workers by withholding certain sums from their paychecks, a policy that streamlined collection and significantly increased the number of taxpayers.

Most debates about the income tax today revolve around three issues: the appropriate overall level of taxation; how graduated, or "progressive" the tax should be; and the extent to which the tax should be used to promote social objectives.

The overall level of taxation is decided through budget negotiations. Although Americans allowed the government to run up deficits, spending more than it collected in taxes during the 1970s, 1980s, and the part of the 1990s, they generally believe budgets should be balanced. Most Democrats, however, are willing to tolerate a higher level of taxes to support a more active government, while Republicans generally favor lower taxes and smaller government.

From the outset, the income tax has been a progressive levy, meaning that rates are higher for people with more income. Most Democrats favor a high degree of progressivity, arguing that it is only fair to make people with more income pay more in taxes. Many Republicans, however, believe a steeply progressive rate structure discourages people from working and investing, and therefore hurts the overall economy. Accordingly, many Republicans argue for a more uniform rate structure. Some even suggest a uniform, or "flat," tax rate for everybody. (Some economists – both Democrats and Republicans – have suggested that the economy would fare better if the government would eliminate the income tax altogether and replace it with a consumption tax, taxing people on what they spend rather than what they earn. Proponents argue that would encourage saving and investment. But as of the end of the 1990s, the idea had not gained enough support to be given much chance of being enacted).

Over the years, lawmakers have carved out various exemptions and deductions from the income tax to encourage specific kinds of economic activity. Most notably, taxpayers are allowed to subtract from their taxable income any interest they must pay on loans used to buy homes. Similarly, the government allows lower- and middle-income taxpayers to shelter from taxation certain amounts of money that they save in special Individual Retirement Accounts (IRAs) to meet their retirement expenses and to pay for their children's college education.

The Tax Reform Act of 1986, perhaps the most substantial reform of the U.S. tax system since the beginning of the income tax, reduced income tax rates while cutting back many popular income tax deductions (the home mortgage deduction and IRA deductions were preserved, however). The Tax Reform Act replaced the previous law's 15 tax brackets, which had a top tax rate of 50 percent, with a system that had only two tax brackets – 15 percent and 28 percent. Other provisions reduced, or eliminated, income taxes for millions of low-income Americans.