Introduction

While the United States is accurately characterized as a capitalistic system in which the ups and downs of the market are largely dictated by the economic transactions of individuals and groups, the United States Government nonetheless plays a significant role in regulating the nation’s economy. The government’s economic policies can generally be broken down into two major categories: monetary policy and fiscal policy.

Monetary Policy

New York Stock Exchange. Stock prices (and the world economy) are sensitive to U.S. monetary and fiscal policy. What happens on Washington more often than not has a direct impact on Wall Street.

The Constitution grants Congress the authority to coin money and to establish its value. The federal government’s monetary policies are aimed at managing the economy by regulating the money supply. By making monetary adjustments, the government attempts to keep inflation and unemployment under control. The primary mechanism used for this purpose it the Federal Reserve Board’s control of the “discount rate” on which banks base their interest rates. The Federal Reserve Board (often called the “Fed”) is a private-public banking regulatory body established in the early 1900s. During difficult economic times, the Federal Reserve will usually lower interest rates to encourage investment in the economy. When the economy is booming, the Fed will sometimes raise interest rates to keep inflation under control. 

The Federal Reserve System

The Federal Reserve acts as an independent central bank—its decisions do not have to be affirmed by the president or the Congress. While the Congress retains ultimate authority to coin and print money and to set its value, it delegated this authority to the Federal Reserve Board with the Federal Reserve Act of 1913. Fearful that the Federal Reserve was growing too independent, the Congress passed the Humphrey-Hawkins Act of 1978 requiring the Federal Reserve to submit a report on the state of the economy to Congress twice a year. The report is presented by the Chairman of the Federal Reserve Board of Governors at hearings before committees in the U.S. Senate and House of Representatives.

The Federal Reserve System was explicitly empowered by the Congress “to provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

The Federal Reserve System is made up of a Board of Governors and twelve regional Federal Reserve Banks located in major cities throughout the country. There are seven members that sit on the Board of Governors. Each member must be nominated by the president of the United States and confirmed by the Senate. Members are appointed to serve fourteen-year nonrenewable terms. The president also nominates members of the Board to serve as Chair and Vice Chair for four-year renewable terms. These appointments must also be confirmed by the Senate.

The most important policy making body of the Federal Reserve System is the Federal Open Market Committee (FOMC). It is composed of the seven Governors, the president of the Federal Reserve Bank of New York, and four other Reserve Bank presidents that serve on a rotating basis.

The FOMC can effect monetary policy using the following three tools:

1. Open market operations—the buying and selling of U.S. government securities
2. Altering reserve requirements—the amount of funds that commercial banks must hold in reserve against deposits
3. Adjusting the discount rate—the interest rate charged to commercial banks

These tools can be used to tighten or expand the money supply. For example, if the FOMC wants to control inflation, it can restrict the nation’s money supply by selling government securities and raising the amount of money that banks need to set aside for reserve requirements. Both of these actions would take money out of circulation. In theory, a smaller supply of money would lead to less spending which would lead to lower prices. The FOMC can also raise interest rates to help control inflation. By making money more expensive to borrow, consumers would be more likely to save money rather than spend it. This could also lead to lower prices.

The FOMC meets eight times during the year to consider economic developments and to vote on policy. In the year 2000 Federal Reserve officials raised interest rates several times. In May the committee voted to raise short-term interest rates by half of a percentage point to 6.5%, the highest level since 1991. This was done in an effort to slow the pace of the U.S. economy and keep inflation at a low, manageable level. By early 2001, however, the Federal Reserve cut interest rates to stimulate a stagnant economy.

Fiscal Policy

Fiscal policy is established by the Congress and the president through the federal budget process. Through this process, the federal government determines who will be taxed, what types of income and activities will be taxed at what rates and what will be done with the money that is collected.

Taxation and Spending

Detailed information about the federal government’s spending is available in the Federal Budget.

The table below provides an overview of the impact of the federal budget on the nation’s economy. The impact of government, however, is not limited to federal taxing and spending policies. Individuals and corporations are generally required to pay additional state and local income taxes. State and local governments also collect a variety of other taxes, most notably sales taxes and property taxes.

When taxes are discussed, much of the debate centers on tax “fairness.” How much should an individual or corporation be required to pay in taxes? Should wealthy people be required to pay a higher percentage of their income than those that are less well off? Should the government redistribute income by taxing the rich and giving some of that money to the poor? None of these are easily answered questions, but they must be addressed and answered—at least tentatively—when the federal government establishes their taxation policies each year.

Some people believe a tax is fair when it is progressive, i.e. tax rates increase as income increases. For example, under a progressive tax system, an individual who earns $20,000 a year would be taxed at a lower rate than would an individual who earns $100,000 a year. Others believe that fairness means tax rates are “flat” or proportional, i.e. all individuals are required to pay the same percentage of their incomes, regardless of how much they earn each year. Over the past several years many politicians have called for a flat, or at least “flatter,” tax system in the United States.

While most Americans support either a progressive or proportional tax system, few if any are explicitly in favor of a regressive tax system, one in which individuals with lower incomes are taxed at higher rates than wealthier individuals.

There are, though, examples of such taxes in the American system. Local taxes on food, for example, tend to be regressive. Given a sales tax on food of 5% and an income of $30,000, a family that spends $4,000 a year on food would pay $200 in food taxes a year, or .7% of its annual income. Comparatively, a wealthier family with an annual income of $150,000 that spent $8,000 a year on food would pay $400 in food taxes, or .3% of its annual income. The wealthier family is effectively taxed at less than half the rate of the lower-income family. Many states that collect taxes on food offer tax credits or rebates to low-income families to mitigate the regressive nature of such taxes. Another example of a regressive tax in the United States is the payroll tax (FICA) because no social security taxes are assessed on income over $80,400.

Terms and Concepts

• Fiscal policy: policies and programs establishing budgetary policy, including types and rates of taxation and types and amounts of spending.
• Flat tax: tax collected at the same rate or percentage regardless of income level.
• Monetary policy: policies aimed at controlling inflation and unemployment through manipulation of the money supply and interest rates. Primarily established by the Federal Reserve Board.
• Progressive tax: tax collected at increasingly higher rates or percentages as income level increases.
• Regressive tax: tax collected at increasingly lower rates or percentages as income level increases.

Think About It

• In your opinion, what kind of tax (progressive, regressive or proportional) is the most fair?
• Why is monetary policy controlled by an independent, nonpolitical body (the Federal Reserve Board) while fiscal policy is made by the president and Congress?

Read About Current Tax Policy Controversies

Budget surpluses and tax-cuts tax policies are almost always controversial. Policy makers in Washington constantly argue over the wisdom of cutting or raising taxes. If there are budget surpluses, should some of the money the government has raised be “refunded” to the people, or should be spent to reduce the debt and stabilize Social Security and Medicare? Or should the government pursue both policies—cut taxes and set aside some of the surplus money for other purposes?

• Tax Policy Center Brookings Institution and the Urban Institute
• Budget and Tax Policy Cato Institute

Economic Policy Resources on the Web

• Federal Reserve Board
• Internal Revenue Service