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Political Economy

Fiscal Policy

Economic Growth

Monetary Policy

A government affects the economy in many ways, including through fiscal policy, the way the government taxes its population and spends its resources, and through monetary policy and regulation, which is covered later. All governments require money to operate, so they raise money through taxation. Often governments augment the income generated through taxation by borrowing money. Most governments tax and spend using myriad methods, including spending, borrowing, and running deficits, all of which strongly affect the economy.


Fiscal Policy

Monetary Policy


Governments create tax policies and budgets that allow them to allocate resources the most efficiently. Governments control the amount of money circulating in the economy to control inflation, borrowing, and spending in order to stabilize the economy. Governments establish economic rules to protect consumers, balance labor and capital, and foster an atmosphere of fair trade.


Taxes are seldom neutral. Most tax systems produce winners and losers because governments frequently use their tax policies to encourage—or discourage—certain types of behavior. If a government wants to reward investment, for example, it might cut taxes on capital gains (income earned from selling investments). Alternatively, if a government wishes to discourage drinking alcohol, it might tax liquor at a high rate.

In addition to various taxes on goods and services, most governments rely on one, some, or all of three types of income taxes: progressive, regressive, and flat. Progressive and regressive taxes directly affect income distribution. Regardless of which tax system is used, governments shape people’s behavior through the taxes they levy on citizens.

Example: The U.S. government has used tax policy to achieve housing goals. For the past fifty years, the federal government has allowed homeowners to deduct mortgage interest from income when determining taxes. This deduction encourages people to buy houses because owning a home can help them save substantially on their tax bill. Because most people who buy houses have a moderate or greater income, the effect of this tax policy is to create a subsidy for housing for the middle and upper classes. In fact, the total cost to the federal government of the home mortgage interest deduction is roughly two and half times what the federal government spends on housing for the poor.

Progressive Taxes

Progressive taxes favor the poor. The rich must pay a higher percentage of their income than the poor in a progressive taxation system. For example, U.S. federal income taxes charge lower income groups about 10 percent of their income, whereas richer people must pay substantially more (more than 20 percent in some cases). People who favor these taxes argue that because the rich can afford to pay more, they should pay more. Progressive taxes attempt to create economic equality. Such policies are sometimes called redistributive because they shift money from one group to another.

Regressive Taxes

Regressive taxes cost the poor a larger portion of their income than they do the rich. Social security taxes are an example of regressive taxes because everyone who earns a paycheck must pay based on their earnings. Wage earners are taxed at a set rate but only on the first $90,000 (approximately). So someone who earns $90,000 pays the same dollar amount as someone who makes $30,000, but the person who earns $30,000 shells out a far bigger percentage of his or her income than the person who earns $90,000. Like progressive taxes, regressive taxes are redistributive, but regressive taxes shift money toward the rich rather than toward the poor.

Flat Taxes

Flat taxes charge everyone the same rate, regardless of income. In practice, there are not many flat taxes in the United States. Even some of the flat tax proposals put forward are not truly flat.

Example: Although the United States may not have many flat taxes, other countries do. In fact, during the last ten years, many countries in Eastern Europe (including Russia, Ukraine, Romania, and Georgia) have adopted flat taxes ranging between roughly 10 and 30 percent of income. The governments of these countries instituted the flat tax with the hope that a simpler tax system with fewer loopholes and opportunities for tax shelters would actually increase the amount of taxes they collected from wealthier individuals and corporations.

Other Taxes

Income taxes are certainly not the only kinds of taxes levied by governments. The taxes used by governments include the following:

  • Sales tax (also known as excise tax): A tax paid on purchases; the buyer pays a percentage of the price of the item as tax
  • Luxury tax: A tax levied on the purchase of extremely expensive luxury items
  • Property tax: A tax levied on property owners, usually a percentage of the value of the property
User Fees

Governments can also raise money through user fees, the money charged to citizens for doing certain things. Examples include fees for using public parks, fees for obtaining licenses (such as a driver’s or hunting license), or charging tolls for using certain roads. User fees are a popular way to raise revenue because they are not technically taxes, and they only affect those who use the particular government service.

Tax Credits

Governments use tax credits to alleviate the income tax burden for some activities. A tax credit is deducted from the amount of taxes a person owes. A good example is the Earned Income Tax Credit program in the United States. The EITC gives lower-income workers back some of the money they paid in payroll taxes. Tax credits are also known as tax expenditures.


A loophole is a specific provision within a tax law that allows individuals or corporations to reduce the amount they owe in taxes. Politicians put loopholes in tax law in order to reward certain types of behavior (investing in alternate fuel sources, for example). In the United States, the number of loopholes has expanded greatly since the last major tax reform of 1986.

Loopholes and tax credits mean that a person usually does not pay the given tax; he or she usually pays less. The effective tax rate is the percentage of income that one actually pays in taxes.

Example: In the United States, few people pay the basic rate on their income tax. Every taxpayer is allowed a deduction (standard or itemized), and most are allowed to deduct certain exemptions from their taxable income. Other deductions and credits can reduce the tax burden further. In some extreme cases, people making millions of dollars pay very little in tax because of tax loopholes, deductions, and shelters (a catch-all term for anything that reduces the amount of taxable income).

Government Spending and Borrowing

Government spending and borrowing affect the economy. Most governments spend a great deal of money in their annual budgets. How that money is spent affects people in different ways. Some expenditures create jobs, thereby lessening unemployment. Other expenditures subsidize certain industries, as when a government buys a fleet of cars to aid the automotive industry. Governments also spend money on infrastructure (such as building roads) and defense (such as counterterrorism and the military). Other expenditures, such as worker training, can boost the economy too.

Balanced Budgets and Surpluses

When a government spends the same amount of money it takes in, the government has balanced the budget. A surplus arises when a government receives more money than it spends.

Deficits and Debt

When a government spends more than it takes in, it runs a deficit. Taxes raise only a limited amount of money, so if governments wish to spend more than they have made, they must borrow the difference. The total of all deficits owed by a government is the national debt (also called the public debt), which must be repaid eventually. Generally, governments tolerate and accept some debt, but too much debt carried for too long causes serious problems.

Example: As of February 2010, the United States had a national debt of over $12 trillion.

Governments most often borrow money by issuing government bonds. When a person buys a bond, the government promises to pay back the purchase price plus interest to the owner. In the United States, bonds are sometimes called T Bonds or T Bills because they are issued by the Treasury Department.

Government Spending and Inflation

Large-scale government spending can increase inflation. If the government buys a lot of goods, it causes an increase in demand for those goods, which causes prices to rise. Sometimes governments are willing to tolerate some rise in inflation to stimulate the economy, but over time, excessive spending and high inflation can create problems.

Government Borrowing and Interest Rates

Government borrowing sometimes creates problems because it drives up interest rates. Interest, or the price of borrowing money, goes up when there is an increase in demand for borrowing, which is why heavy government borrowing often drives up interest rates. High interest rates, in turn, hurt the ability of citizens and businesses to borrow money. This chain reaction slows the economy.

Keynesian Economics

In the early years of the twentieth century, economist John Maynard Keynes argued that governments should step in to actively help the economy. According to Keynesian economics, government spending during a recession shortens the length of the recession and keeps the recession from becoming severe. Often this process entailed deficit spending, or intentionally spending more money than the government has.

Demand-Side Versus Supply-Side Economics

Keynesian economics is categorized as demand-side economics. It stimulates consumer demand by putting more money into consumers’ hands in order to improve the economy. In contrast, supply-side economics tries to improve the economy by providing big tax cuts to businesses and wealthy individuals (the supply side). These cuts encourage investment, which then creates jobs, so the effect will be felt throughout the economy. Supply-side economics is sometimes called trickle-down economics. Although demand-side economics has worked very successfully in much of the world since World War II, some economists and policymakers favor supply-side economics. Also, a number of recent American presidents, most notably Ronald Reagan, have relied on supply-side economics to pull the economy out of recessions.

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