1.3 Fiscal Policy

While the Federal Reserve controls monetary policy, Congress and the President control fiscal policy — decisions about government taxation and spending. Investment advisers must understand how fiscal policy affects economic conditions and securities markets.

What Is Fiscal Policy?

Fiscal policy involves government decisions about:

- Taxation — How much revenue the government collects from individuals and businesses

- Government Spending — How much the government spends on programs, services, and infrastructure

Unlike monetary policy (controlled by the independent Fed), fiscal policy is inherently political — it requires Congressional action and Presidential approval.

Components of Fiscal Policy

Government Spending

Government spending injects money directly into the economy through:

Defense: Military personnel, equipment, operations

Entitlements: Social Security, Medicare, Medicaid

Discretionary: Education, transportation, research

Infrastructure: Roads, bridges, public facilities

Interest Payments: Interest on the national debt

Taxation

Taxation removes money from the private economy:

Individual Income Tax: Workers, investors (on wages, capital gains, dividends)

Corporate Income Tax: Businesses (on profits)

Payroll Taxes: Workers and employers (Social Security, Medicare)

Excise Taxes: Consumers (on specific goods like gasoline, alcohol)

Estate/Gift Taxes: Wealthy individuals transferring assets

Types of Fiscal Policy

Expansionary Fiscal Policy

Expansionary fiscal policy is used to stimulate a sluggish economy:

Increase government spending: Directly adds to demand; creates jobs

Decrease taxes: Puts more money in consumers' pockets

Result: Budget deficits (spending exceeds revenue)

Example: The 2020-2021 COVID-19 relief packages totaling over $5 trillion combined increased spending (stimulus checks, enhanced unemployment) with tax relief to combat the pandemic recession.

Contractionary Fiscal Policy

Contractionary fiscal policy is used to slow an overheating economy:

Decrease government spending: Removes demand from economy

Increase taxes: Takes money out of consumers' pockets

Result: Budget surpluses (revenue exceeds spending)

Contractionary fiscal policy is politically unpopular and rarely used deliberately. More often, governments reduce the pace of spending growth or let tax cuts expire.

Fiscal Policy vs. Monetary Policy

Investment advisers must understand how these two policy types differ and interact:

Controlled By: Fiscal Policy — Congress and President; Monetary Policy — Federal Reserve

Primary Tools: Fiscal Policy — Taxes and spending; Monetary Policy — Interest rates and money supply

Political Process: Fiscal Policy — Highly political; requires legislation; Monetary Policy — Independent; FOMC decisions

Speed of Implementation: Fiscal Policy — Slow (months to pass legislation); Monetary Policy — Fast (FOMC meets 8 times/year)

Timing: Fiscal Policy — Often implemented too late; Monetary Policy — Can respond quickly to conditions

Precision: Fiscal Policy — Blunt instrument; Monetary Policy — Can be more targeted

How They Work Together

During recessions, both policies are often expansionary:

- Fed: Lowers rates, buys securities

- Congress: Increases spending, cuts taxes

During overheating economies:

- Fed: Raises rates, sells securities (contractionary)

- Congress: May reduce spending or raise taxes (though politically difficult)

Sometimes they work at cross-purposes (e.g., Fed tightening while Congress spending heavily), which creates policy uncertainty.

The Multiplier Effect

Government spending can have a multiplied effect on economic activity:

How It Works:

1. Government spends $1 million on infrastructure

2. Construction workers receive wages

3. Workers spend on groceries, housing, entertainment

4. Those businesses pay their workers

5. Those workers spend again

Result: That initial $1 million generates more than $1 million of economic activity.

The multiplier effect depends on the marginal propensity to consume (MPC) — how much of each additional dollar people spend rather than save. Higher MPC = larger multiplier.

Budget Concepts

Budget Deficit vs. Surplus

Budget Deficit: Government spends more than it collects in taxes. Example: Most years since 2000

Budget Surplus: Government collects more in taxes than it spends. Example: Late 1990s (1998-2001)

Balanced Budget: Spending equals revenue. Rare

National Debt vs. Annual Deficit

These terms are often confused:

Annual Deficit: One year's shortfall (spending - revenue). 2025 Approximate Level: about $1.9 trillion

National Debt: Cumulative total of all past deficits. 2025 Approximate Level: about $36 trillion

Debt-to-GDP Ratio: Debt as percentage of economic output. 2025 Approximate Level: about 100%+

Analogy: The deficit is like your annual credit card bill; the national debt is your total outstanding balance.

Debt Ceiling

The debt ceiling is a legal limit on how much the federal government can borrow. Congress must vote to raise it periodically, which often becomes politically contentious.

Impact on Investments

Fiscal policy affects securities markets through several channels:

Stocks

Tax cuts (personal): Positive — consumers have more to spend

Tax cuts (corporate): Positive — higher after-tax earnings

Increased spending: Positive — more economic activity

Tax increases: Negative — less consumer spending

Spending cuts: Negative — reduced economic activity

Bonds

Large deficits: Negative — increased supply of Treasury bonds

Reduced deficits: Positive — less Treasury bond issuance

Concerns about debt: Negative — investors may demand higher yields

Specific Sectors

Fiscal policy directly affects some sectors more than others:

Defense contractors: Military spending decisions

Healthcare: Medicare/Medicaid policy

Construction: Infrastructure spending

Municipal bonds: State and local tax policy

In Practice: How Investment Advisers Apply This

Monitoring fiscal policy changes:

- Tax reform can affect after-tax investment returns

- Changes to capital gains rates affect selling decisions

- Estate tax changes affect wealth transfer planning

- Infrastructure bills may benefit specific sectors

Client conversations:

- Help clients understand that fiscal stimulus may lead to future tax increases or inflation

- Discuss how budget deficits may eventually affect interest rates

- Consider tax-advantaged investments when tax rates rise

On the Exam

The Series 65 exam tests your understanding of:

1. Difference between fiscal and monetary policy

2. Expansionary vs. contractionary fiscal policy

3. Deficit vs. debt — annual shortfall vs. cumulative total

4. Impact on securities markets

5. Who controls fiscal policy (Congress and President, not the Fed)

Key Takeaways

- Fiscal policy involves government taxation and spending decisions

- Controlled by Congress and the President (not the Federal Reserve)

- Expansionary policy: Increase spending and/or cut taxes (creates deficits)

- Contractionary policy: Decrease spending and/or raise taxes (creates surpluses)

- Budget deficit = one year's shortfall; national debt = cumulative total

- Fiscal policy works more slowly than monetary policy due to the legislative process

- The multiplier effect means government spending can generate more than $1 of activity per $1 spent

- Investment advisers should monitor fiscal policy for sector and tax implications