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Fiscal policy uses public spending levels and tax rates to influence the economy. Policymakers use fiscal policy to find a level of public spending that stimulates economic demand without creating an undue tax burden for citizens and businesses.
Key Takeaways
- Economists and government officials often debate the benefits of higher versus lower tax rates.
- President Ronald Reagan’s tax policies were based on supply-side or trickle-down economics.
- Under President Bill Clinton, the top income tax rate was increased to 36%, and the corporate tax rate was raised to 35%.
- President Obama pushed for higher taxes on the wealthy to decrease the federal deficit, and President Trump focused his efforts on across-the-board tax decreases.
“Reaganomics”
Ronald Reagan promoted economic growth by reducing tax levels with policies based on “supply-side” or “trickle-down” economics, dubbed “Reaganomics.” Reagonomics held that upper-income taxpayers with reduced taxes would spend more and invest in businesses, driving economic expansion and job growth. Reagan integrated the economic theories of Arthur Laffer, who summarized the hypothesis in a graph known as the “Laffer Curve.” Congress agreed to a 25% overall rate cut in late 1981 and indexed rates for inflation in 1985.
Initially, inflation was reignited, and the Federal Reserve hiked interest rates. This caused a recession that lasted for about two years. But once inflation was controlled, the economy grew, and 16.5 million jobs were created during Reagan’s two terms. However, the national debt increased. While gross domestic product (GDP) rose approximately 34% during Reagan’s presidency, it’s impossible to determine how much of that growth was due to tax cuts versus deficit spending.
Clinton Years
Under President Bill Clinton, the Omnibus Budget Reconciliation Act passed in 1993 and included a series of tax increases. It hiked the top income tax rate to 36%, with an additional surcharge of 10% for the highest earners.
It removed the income cap on Medicare taxes, phased out certain itemized deductions and exemptions, increased the taxable amount of Social Security, and raised the corporate rate to 35%.During Clinton’s presidency, the economy added approximately 18.6 million jobs. The stock market went on a bull run, as the S&P 500 index rose 210%.
By 1997, unemployment had dropped to 5.3%, and Republicans passed the Taxpayer Relief Act. This act reduced the top capital gains rate from 28% to 20%, instituted a $500 child tax credit, exempted a married couple from $500,000 of capital gains on the sale of a primary residence, and raised the estate tax exemption from $600,000 to $1 million. It also created Roth IRAs and education IRAs and raised the income limits for deductible IRAs.
Policy Under President Obama
President Barack Obama consistently pushed for higher taxes on the rich to help reduce the deficit. He also fought for and passed significant tax relief for working families and small businesses. For the typical middle-class family, tax cuts totaled $3,600 over the first four years.
Although President Obama targeted new opportunities for savings like the Earned Income Tax Credit (EITC), the Child Tax Credit (CTC) for working families, and the American Opportunity Tax Credit (AOTC) for college tuition, to provide about 24 million working and middle-class families a year a tax cut of about $1,000, the national deficit rose during his eight years in office from $7.5 trillion in 2009 to $14.1 trillion in 2016.
Trump’s Tax Cuts and Jobs Act
President Trump signed the Tax Cuts and Jobs Act (TCJA) into law on Dec. 22, 2017, with significant changes to the tax code. The Act reduced marginal effective tax rates on new investments and reduced the differences in rates across asset types, financing methods, and organizational forms.
The TCJA included $5.5 trillion in gross tax cuts, nearly 60% of which goes to families. The economy grew faster after 2017 than predicted before TCJA, but studies show that it significantly reduced federal revenue relative to what would have been generated without TCJA. However, in the third quarter of 2020, real GDP grew at an annualized rate of 33.1%, doubling a previous record set seventy years prior.
President Biden’s Proposals
President Biden’s Fiscal Year 2024 Budget includes tax increases that would target businesses and high-income individuals and capture $4.8 trillion. According to the Tax Foundation, the budget would reduce economic output by about 1.3% in the long run and eliminate 335,000 full-time jobs. However, the Office of Management and Budget (OMB) estimates the FY 2024 budget would reduce the debt-to-GDP ratio by seven percentage points.
The debt-to-GDP ratio compares a country’s public debt to its gross domestic product (GDP). Often expressed as a percentage, this ratio is the years to repay debt if GDP is dedicated to debt repayment.
Do Stimulative Tax Policies Increase the GDP?
According to the World Bank, during the period 1981 to 2000, which encompassed both Reagan and Clinton, the tax revenue as a percentage of U.S. GDP hit a low of 9.9% and a high of 12.9%. This may indicate that the best way to jump-start revenues is to grow the economy through stimulative tax policies.
Does Fiscal Policy Affect Everyone Equally?
Depending on the political leanings and goals of the policymakers, a tax cut could affect only the middle class, commonly the largest economic group. Some policies target corporations or wealthy citizens. Similarly, when a government adjusts its spending, its policy may affect only a specific group of people or businesses.
How Does Keynesian Economics Influence Fiscal Policy?
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
The Bottom Line
Economists and policymakers debate whether higher rates result in increased tax revenues. Fiscal policy tries to strike a balance between public spending levels and tax rates to influence the economy as measured by the tax-to-GDP ratio. In a constant balancing act, policymakers must weigh new taxes against losses that society might face due to those taxes. Changes in rates alter behavior, and taxpayers commonly focus on minimizing their tax burden.