Fiscal policy: A tale of several acts

Fiscal thrust. Fiscal drag. Fiscal impulse. Fiscal headwinds. A lot of nomenclature gets thrown around when discussing how government spending is impacting economic activity. Different measures and methodologies can sometimes lead to conflicting conclusions about how tax dollars are flowing through the broader macroeconomic landscape. US fiscal policy over the last three years undoubtedly had a massive impact on the economy’s response to the global pandemic, but we now find ourselves in a situation where the impact of future government spending is less clear. Furthermore, the government recently reported that the deficit surged to $1.7 trillion for the year ended September 30, 2023, a concerning number. We will walk through a few common ways of measuring fiscal policy as it relates to the economy and discuss some of the underlying details that are important for investors to consider.

The deficit

The US has been running a budget deficit for most of the twenty-first century (see Exhibit 1).

A simple way to consider how much government policy is flowing through to the economy is to consider the year-on-year change of the government deficit (see Exhibit 2).

The current budget deficit as a percentage of gross domestic product (GDP) is roughly 4% higher than it was a year ago. Some will point to this chart as ‘fiscal thrust’ and infer that current fiscal policy should be positively contributing to economic growth. However, we think a deeper dive is warranted to really understand what is happening. It is important to remember that the deficit has two sides to the equation: spending and revenue (see Exhibit 3).

When deconstructing the annual deficit into its two respective components, it is interesting to note that the larger contributor to the current change is actually a decrease in government tax receipts. We believe there are two primary drivers for this decline in revenue. First, after an abysmal 2022 calendar year for both stocks and bonds, capital gains taxes collected in 2023 declined sharply. Second, several states, including California, Alabama, and Georgia, were granted tax waivers due to natural disasters, delaying the deadline to file federal tax payments, according to the IRS website. The important takeaway here is that it is hard to imagine a decrease in government tax receipts as being supportive to US economic activity. On the spending side, government spending has ticked back into a positive year-on-year print, but again we think it is worth looking into the details (see Exhibit 4).

Breaking down the underlying components of government outlays shows that the recent uptick is driven almost entirely from increased interest expense due to the increased Federal Reserve policy rates. We consider this another example of data contributing to fiscal thrust that in reality is in no way stimulative to economic growth.

GDP

The growth in the US economy is generally attributed to four major components: consumption, investment, government spending, and net exports. We think an evaluation of how the contribution to GDP from these four categories changes on an annual basis tells an interesting story of the government’s response to the COVID-19 pandemic (see Exhibit 5).

We can see from the chart that the government contribution to GDP grew rapidly for a few quarters during and post-COVID. However, in 2021 to 2022, this trend reversed as the government GDP contribution normalized. Meanwhile, the consumer component became a larger share of total GDP as consumers spent their excess savings accumulated during the pandemic, the result of fiscal stimulus and pent-up demand. With this particular fiscal support waning, year to date both of these categories have remained stable while gains in net exports have been offset by investment.

While this narrative generally aligns with our views on how the economy has evolved over the past few years, we think it may not accurately reflect the total role fiscal policy has played for two primary reasons. First, there is the issue of transfer payments. While the chart above reflects robust consumption in 2021, we believe this activity was primarily driven by the transfer of payments made to consumers from the government through various fiscal policies, which allowed those consumers to spend at elevated levels for an extended period of time. Second, multiplier effects may be underrepresented. Direct government spending is captured above, but the impact to the supporting economies and infrastructures may be captured elsewhere, resulting in a more muted picture of overall government impact.

Another area where fiscal policy impacts may not be fully reflected is private sector spending, where there is an expectation of future fiscal support.