Taxation and Government Spending

The other main institution that controls the economy is the government. The government controls the economy through fiscal policy, which includes taxation and spending.

Government spending includes spending on things like infrastructure, defense, education, and health care. This spending boosts the economy by creating demand for raw materials, equipment, and labour. The jobs created by this increase disposable income to the newly employed individuals, further boosting the economy through consumer spending.

Additionally, investing in things like infrastructure and education can boost productivity over the long-term by increasing operational efficiency and boosting the skills of employees. This can be thought of as increasing the potential output of the economy.

For investors, watching the sectors where the government directs spending can provide significant opportunities. Businesses in the sectors that are the recipient of government spending will usually benefit greatly. For example, the Inflation Reduction Act signed in 2022 saw significantly increased funding to clean energy projects, which benefited renewable energy stocks like First Solar (FSLR) and Enphase Energy (ENPH). Another example is the Infrastructure Investment and Jobs Act that was passed in 2021, which benefited stocks in the mining, construction, and transportation industries like Brookfield Infrastructure (BIP) and Caterpillar (CAT).

The other aspect of fiscal policy is taxation. Governments can boost the economy by lowering tax rates for individuals and corporatins. By lowering taxes, individuals get more disposable income to spend on goods and services. Businesses benefit from increased after tax profit and can afford to increase hiring or return excess capital to shareholders.

However, tax rates can't be lowered too far because governments need revenue to operate.

Government Debt

Taxation is just one of the government's sources of income. Governments can also loan money from investors by issuing government bonds and increasing the national debt.

The difference between revenue to the government and spending is called the budget. When the budget is negative it is said to be in a deficit. When the budget is in a deficit, the government's income is less than expesnses so the national debt increases.

However, much like a business, having some amount of debt is completely normal for governments as it allows them to spend on things that benefit the economy, like infrastructure, health care, and education, that they otherwise couldn't afford. In fact, almost all countries carry some debt for this reason.

The problem is when debt becomes too high. If government debt becomes too high, the capacity for spending on essential functions like infrastructure and defense becomes limited. This can slow economic growth and cause widespread financial instability. In extreme circumstances, governments can default on their debt. If this happens, the government could be forced to shut down until the debt is repaid or restructured. The money of everyone who lent to the government (other countries, institutions, and individuals) would be lost, and it would be much harder for the government to ever borrow money again. This has happened numerous times throughout history. You can see a list of times governments have defaulted here.

A common metric for measuring a country's debt level is by comparing it to GDP. For example, the US has the largest national debt in the world at $35 trillion, but it also has the largest GDP in the world at $29.35 trillion. On the debt-to-GDP metric, the US ranks 39th in the world.

When debt becomes due, governments will usually pay it by issuing more bonds. This is much quicker and easier than increasing taxes, which take time to flow back to the government.

In the US, the maximum amount a government is allowed to raise by issuing bonds is called the debt ceiling. The debt ceiling is supposed to ensure government debt remains within a limit that is sustainable. However, the ceiling has proved fluid since, to date, the ceiling has been raised or suspended every time the US national debt has approached the limit to avoid a government shutdown.

Relationship with Monetary Policy

The monetary policy of central banks and the fiscal policy of government are related but work separately to control the economy.

If government significantly cuts taxes, the central bank will likely be required to raise interest rates to prevent inflation. So while after-tax incomes may go up, costs may increase elsewhere (for example on your mortgage or credit card repayments).

Repayments on government debt are also affected by interest rates. Remember that interest rates are the cost of borrowing, and they affect the government too. If interest rates rise significantly, the government has to increase the interest rate on its bonds in order to convince investors to buy them. This can affect the budget and force the government to increase taxes or cut spending, especially if government debt is high.

Because they are mandated to control the economy, the influence of central banks on the economy through monetary policy is generally more significant than that of the government. But it is still important to pay attention to fiscal policy.