Chapter 27: Government and Fiscal Policy

Start Up: A Massive Stimulus

Shaken by the severity of the recession that began in December 2007, Congress passed a huge $787 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.

Roughly a third of the Recovery and Reinvestment Act is for a variety of tax cuts for individuals and firms. For example, each worker making less than $75,000 a year will receive $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 are eligible for $2,500 tax credits for educational expenses. The other two-thirds is for a variety of government spending programs. 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

The measure 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. According to an estimate by the Congressional Budget Office (CBO), only about 20% of the spending called for by the legislation will take place in 2009, rising to about two-thirds through the middle of 2010. It is a guess what state the economy will be in then.

A fiscal stimulus package of over $150 billion had already been tried earlier in February 2008. It included $100 billion in 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 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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