Chapter 12: Government and Fiscal Policy

Start Up: A Massive Stimulus

Shaken by the severity of both the recession that began in December 2007 and the financial crisis that occurred in the fall of 2008, Congress passed a huge $784 billion stimulus package in February 2009. President Obama described the measure as only “the beginning” of what the federal government ultimately would do to right the economy.

Over a quarter of the American Recovery and Reinvestment Act (ARRA) was for a variety of temporary tax rebates and credits for individuals and firms. For example, each worker making less than $75,000 a year received $400 ($800 for a working couple earning up to $150,000) as a kind of rebate for payroll taxes. That works out to $8 a week. Qualifying college students became eligible for $2,500 tax credits for educational expenses. During a certain period, a first-time homebuyer was eligible for a tax credit. The other roughly three-quarters of the ARRA were for a variety of government spending programs, including temporary transfers to state and local governments, extended unemployment insurance and other transfers to people (such as food stamps), and increased infrastructure spending. The president said that the measure would “ignite spending by businesses and consumers … and make the investment necessary for lasting growth and economic prosperity.”Barack Obama, Weekly Address of the President to the Nation, February 14, 2009, available at Shortly after the passage of the ARRA, Congress passed the Cash for Clunkers program, which for a limited period of time allowed car buyers to trade in less-fuel-efficient cars for rebates of up to $4,500 toward buying new cars that met certain higher fuel-efficiency standards.

The ARRA illustrates an important difficulty of using fiscal policy in an effort to stabilize economic activity. It was passed over a year after the recession began. Only about 20% of the spending called for by the legislation took place in 2009, rising to about two-thirds through the middle of 2010. It was a guess what state the economy would be in then. As it turned out, the recession had officially ended, but there was still a large recessionary gap, and unemployment was still a major concern. There was a great deal of media controversy about how effective the policy had been and whether the resulting increase in national debt was worth it. Concern over the expanded size of the federal government created by the stimulus measures became a rallying cry for the Tea Party movement. A fiscal stimulus package of over $150 billion had already been tried earlier in February 2008 under President George W. Bush. It included $100 billion in temporary tax rebates to households—up to $600 for individuals and $1,200 for couples—and over $50 billion in tax breaks for businesses. The boost to aggregate demand seemed slight—consumers saved much of their rebate money. In November 2008, unemployment insurance benefits were extended for seven additional weeks, in recognition of the growing unemployment problem.

President Obama argued that his proposals for dealing with the economy in the short term would, coincidentally, also promote long-term economic health. Some critics argued for a greater focus on actual tax cuts while others were concerned about whether the spending would focus on getting the greatest employment increase or be driven by political considerations.

How do government tax and expenditure policies affect real GDP and the price level? Why do economists differ so sharply in assessing the likely impact of such policies? Can fiscal policy be used to stabilize the economy in the short run? What are the long-run effects of government spending and taxing?

We begin with a look at the government’s budget to see how it spends the tax revenue it collects. Clearly, the government’s budget is not always in balance, so we will also look at government deficits and debt. We will then look at how fiscal policy works to stabilize the economy, distinguishing between built-in stabilization methods and discretionary measures. We will end the chapter with a discussion of why fiscal policy is so controversial.

As in the previous chapter on monetary policy, our primary focus will be U.S. policy. However, the tools available to governments around the world are quite similar, as are the issues surrounding the use of fiscal policy.


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