Ten Factors that Drive the Performance of an Economy: Factor One Fiscal Policy
Have you ever wondered what caused the Great Depression of the 1930’s or the recent Great Recession? Have you ever wondered what caused the economy to recover from each of those terrible declines? Economists offer numerous explanations, some of which conflict with each other and only a few of which are generally accepted. The answers to these questions are important to investors because the prospective health of an economy plays a key role in the major decisions of an investor. In particular, accurate economic forecasts can allow investors to decide how much risk to take and to formulate financial plans.
This is the first of a ten part series on the reasons why economies – in particular the U.S. economy – prosper or stagnate. The next ten parts of this series discuss ten factors that I believe are important in determining the success or failure of an economy. For each reason, I will offer two grades: a grade as to how important I believe that factor is in driving growth, and a grade for how well-situated the U.S. economy is with respect to that factor. The final part of the series will discuss conclusions.
In all of these discussions one underlying premise prevails: economic growth is good. While to many this premise is obvious, in intellectual circles it is generally disputed. I see economic growth as allowing people to reach goals such as education, housing, healthcare, nutrition, recreation, travel, and entertainment, as well as providing the wealth necessary to address problems such as pollution and poverty. To those who believe that economic stagnation or decline is better, I suggest emigration to Venezuela, South Africa or North Korea, rather than trying to prevent the U.S. economy from growing.
Economic Factor #1: Fiscal Policy
Fiscal policy is the first factor in this ten part series on the factors that determine economic performance. Fiscal policy refers to a government’s policies regarding taxation and spending. Virtually all analysts agree that high taxation discourages whatever it is that is being taxed. We know this and apply this concept in the form of “sin taxes” on alcohol, tobacco, marijuana and gambling. So at least in the short run, high taxes on income and wealth should tend to discourage economic growth, and low taxes should encourage economic growth.
The output and consumption of an economy is the sum of the output plus consumption of its citizens. So what drives the decision of an individual to work hard and produce output that is prized in the marketplace? Clearly, the answer is that the net benefit that the individual receives (after taxes) is the driving factor, since people take actions only when the perceived benefits of that action exceed the perceived costs. I think there is nothing more discouraging to a worker in the long run than the belief that he or she will have little or no ability to receive or at least control who gets the benefits from his/ her hard work.
Unfortunately, the U.S. has been on a long term trend of wasteful spending and increased taxation of the most productive people and entities. This increased taxation and spending occurs at all three levels: Federal, state and local. However, the 2016 elections may mean that at least at the Federal level, America is poised to return to a lower and simpler income tax policy similar to that of the Reagan era (that ushered in almost 20 years of prosperity), rather than return to the destructive high income tax strategy that destroyed American productivity prior to the Reagan era (when the top marginal combined state, local and Federal income tax rates were often well in excess of 80%).
The role of government spending has three major effects. 1. In the long run, the money spent must be generated from taxes, and since taxation inhibits growth, high spending is a negative. 2. Money spent on services essential to the economy (infrastructure, institutions, defense) is money that provides a foundation for economic prosperity. 3. Money spent on services or wealth transfers that enables or even encourages people to be unproductive is detrimental to economic prosperity. So the net effect of government spending depends on whether the money is wisely enough spent to justify the long run tax burden and its drag on the economy. The short run may be OK for the U.S., but the long term trend has been a disaster.
Importance of factor in general: A
Prospective influence of this factor on the U.S. economy: B-