The year 2016–a nationwide stress test–just came to an end. Some say it was a great year, others think the world is ending, and there’s still a group who thinks the world is flat. So any way you look at it, it was a pretty successful year! Despite the usual differing opinions that we see after an election year, there’s one thing we can all agree on – the world is a worse place because Harambe is pushing daisies. Clearly, the only thing we can do to make this post-Harambe apocalyptic era a decent place to live in is to understand fiscal policy. One might ask, “Why should I understand fiscal policy?” or say, “Fiscal policy has never affected my life, I have better things to worry about”. While it may be true that you have more important things to worry about, understanding fiscal policy and the way it affects your life will definitely help you become a real adult in no time! Which leads us to ask, “Just what the heck is fiscal policy?”
Imagine you live in a country that is cut off from the outside world. Your country never trades with anyone and all economic activity only happens within your country. Congratulations, you live in a closed economy! In a closed economy, an economy without imports or exports, fiscal policy is the taxes collected by the government minus the expenditures by the government (i.e. military, stimulus package, etc.). For example, if the government spent $1 trillion on a stimulus package to save the corrupt investment bankers, and only collects $.8 trillion in taxes from the public, the government will have a $.2 trillion budget deficit for that year. Therefore, the taxes the government collects from its citizens pays the expenses that the government incurs. Since fiscal policy affects the government’s budget, fiscal policy and government budgets are inextricably linked together. This is the part where fiscal policy starts affecting your life directly. There’s a possibility of a direct correlation between the size of budget surplus or deficit the government wants to have and what is left in your pocket at the end of the year. Different policies will directly affect your discretionary income, your job, and since money buys happiness, fiscal policy could even affect the smile on your face!
There are two different types of budgets that the government will run for different reasons. One type that the United States consistently utilizes, is a budget that focuses on expanding the economy, aptly named expansionary fiscal policy. Expansionary fiscal policy is when the government’s purchases exceed the taxes collected which puts the government at a budget deficit. The government finances this deficit through issuing debt in the financial markets. This gives them access to fast capital they can pay back at a low interest rate because of their strong credit rating. For example, during the 2008 Financial Crisis the government used a large stimulus to bail out banks that held faulty CDO’s (collateralized debt obligations) to keep the economy from going into a full-on depression. Although in this example the government printed new money to fund this, which is monetary policy, normal stimulus packages are not sprouted from new money. This means the government would be spending from their own budget to fund the stimulus package. This type of aggressive spending by the government is a prime example of expansionary fiscal policy. Expansionary fiscal policy is a great tool for any politician to propose since it brings growth to the economy. However, a lot of economists believe that running too large of a deficit is the country’s way of passing its current problems onto the next generation.
There is also the opposite end of the spectrum where a policy will reduce debt, slow down the economy, and make any politician squeamish.
This squeamish inducing policy is called contractionary fiscal policy. Contractionary fiscal policy is when taxes exceed government expenditures, and this is normally used to pay off debt. This type of policy can be spurred by an increase in taxes or by a decrease in government spending. Either way, this is a sure-fire way to slow the economy down. Economists may propose a contractionary fiscal policy when they believe the economy is too “hot”, or in other words, they’re worrying about the economy expanding too quickly. This could cause a bubble and out of control inflation. The economy is similar to a human body trying to maintain homeostasis. Therefore, the economy is running too “hot” is similar to a person that is working out extremely hard. Obviously, whenever you exert yourself extremely hard there needs to be time to rest and recover. Otherwise, you will injure yourself which will set you back a lot further than if you just took time to rest. The economy is very similar. If it is expanding too quickly, or for too long, it will need to correct itself (i.e. rest and recover) because it will be exhausted.
If the $19.5 trillion of debt hasn’t been a big enough clue, the United States isn’t a huge fan of contractionary fiscal policy. “Why not?” you might ask. The answer: politics. Since we are an instant gratification society, it is extremely difficult for a politician to run on the slogan of increasing taxes (i.e. corporate and personal) while simultaneously reducing government spending unless we are in a world war. Also, contractionary fiscal policy will hurt companies’ bottom line which means corporate earnings will go down. This means that the person who has been investing their savings into the stock market won’t ever want to hear the phrase “contractionary fiscal policy” since it will theoretically reduce the equity value of the securities they own. The reason why earnings are so important is because earnings per share is a barometer of profitability per unit of shareholder’s equity. Therefore, if earnings per share starts to drop then the shares are not as profitable which reduces their value. One of the reasons the stock market has been booming since the election of Donald Trump is because of his plan to lower the corporate tax rate. Company earnings will be positively affected by lowering the corporate tax rate which means ceteris paribus, the intrinsic value of the equities will increase.
As much as I am a fan of gaining useless knowledge to spew out at parties (I am not popular), it is important to be able to apply this knowledge to real world situations. First, by understanding the current fiscal policy and the future fiscal policy it will help plan for the future based on how much personal taxes you might have to pay; and it is even more important to understand this if you’re a business owner. Second, it will help you make decisions about which industries will be most affected by these policies and allow you to allocate your money accordingly. Obviously, understanding how to properly allocate your money based on current policy will give you the ability to make superior decisions which will make you a better investor. Lastly, it will allow you to see the big picture through a clearer frame. This is because fiscal policy is part of the fundamentals of our economic, political, and corporate structure. As we know, there are only two things that are guaranteed in life, death and taxes. Unfortunately, fiscal policy is the ugly monster that is guaranteed to touch one of those, also with the potential to bring the other one sooner than expected.