Reference no: EM13147078

Read the following article and answer the questions at the end.

"But I don't feel stimulated" by John Slayton

PRESIDENT Obama recently signed an $800 billion Stimulus Plan and submitted his 2010 Federal Budget to Congress, resulting in a $1.75 trillion+ increase to the federal deficit. The President hopes to halve the budget deficit within four years, partially through $989 billion in new taxes. Americans making over $250,000 annually will fund up to $700 billion in additional tax revenue over a 10-year period:

 •Expiration of Bush tax cuts - $338 billion

 •Elimination of itemized deductions - $179 billion

 •Raising capital gains tax - $179 billion

The recent heated debate over how to deal with the deepest recession since 1930 has focused on the differences between two historical economic approaches - Supply-Side vs. Demand-Side Economics. It is tempting to dispatch such debates as academic, partisan dribble, but the outcome is going to have a very real impact on our wallets and lifestyles for years to come.

Supply-Side Economics, as popularized by Ronald Reagan and espoused by economists Milton Friedman and Friedrich Hayek, argues that tax cuts to high tax bracket individuals and corporations enable investments in production in the private economy, thereby increasing the supply of goods and employment. The increase in supply drives down prices, increases demand and results in increased economic activity, which results in added tax receipts. As evidenced by the 2001 Bush tax cuts, decreasing tax rates actually results in higher tax receipts. On the other hand, the President and the Congressional majority have firmly embraced Demand-Side Economics, as sponsored by John Maynard Keynes during the Great Depression. Keynes argued that getting an economy out of a rut requires stimulating demand through government spending, tax cuts and rebates to the middle class, so that they demand and spend more. General employment is closely correlated with aggregate demand for consumer goods, so during recessions the government should borrow money and spend it in order to drive the economy. The "Keynesian Multiplier Effect" posits that real GDP rises by more than the actual government spending, because idle resources - unemployed labor and capital - are put to work to produce added goods and services. The Obama budget assumes a multiplier of around 1.5, meaning that every $1.00 the government spends on "shovel-ready" projects and lower/middle class tax credits results in $1.50 benefit to GDP and every 1 percent improvement to the GDP results in 1 million jobs.

During the Great Depression, Keynes argued that with consumer and business spending so weak, governments had to boost demand directly. FDR's public works job programs and the increased government spending during and after World War II eventually ended the Great Depression. Keynesian policies were popular until the late 1970s, when government spending was blamed for spurring worldwide inflation. Supply-siders argued government deficits drive up interest rates and hinder more efficient investments in the private sector. With the rise of Ronald Reagan and Britain's Margaret Thatcher, shrinking government became the predominate goal. Monetary policy began to play a bigger role than fiscal policy, as central bankers drove up interest rates in order to fight inflation. The era from the early 1980s to the recent crisis became known as "the Great Moderation," with less volatility in economic activity and inflation. Unfortunately, monetary policy has not and will not cure the current economic crisis.

The Obama administration and the Democratic Congressional majority are trying to cure our economic woes with increased discretionary spending. Unlike the 1930s, however, discretionary spending on roads or bridges has been marginalized by huge entitlement spending (Medicare, Medicaid and Social Security) and is no longer an effective fiscal tool. Borrowing or printing money to pay for the Stimulus today will result in higher taxes or higher inflation (or both) in the future. Arguably, we should focus on incentives (reduced marginal income tax rates) for people and businesses to invest, produce and work, rather than programs that throw money at people or massive public-works programs that do not pass muster. Stimulus spending that takes resources away from those who are productive and redistributes them to politically favored interests assumes that government knows better how to spend and invest than do private individuals and industry. Income redistribution through a Trojan horse of Democratic policies, cloaked as Stimulus, should not be confused with sound economic theory. In reality, no one spends someone else's money better than they spend their own. The Stimulus Package is all about politics and power, not sound economic theory. To be informed is to be empowered.

Questions

1. Use a Keynesian 45-degree diagram to show the effect of an increase in government spending.

2. How could a reduction in tax rates increase government's tax receipts?