Recent events have seen a dramatic rise in government expenditures. The federal government has increasedspending by $3.6 trillion which is almost double the pre-pandemic spending level. This is in addition to all of the other Federal Reserve activities. All of this activity will a have a dramatic impact on the economy and therefore investors. The question is what will this impact mean for our investment strategy?
Spending is Taxation
First, we need to understand that there is NO difference between public spending and taxes. This is a commonly misunderstood aspect of government expenditure. Even commentators who should know better fall into the trap of differentiating between spending and taxes. So, on one level deficits don’t really matter. It would be better to halve the level of government spending and fund it all through debt than to eliminate the deficit at the current level of spending. Remember this simple equation; government spending = taxation.
Taxation comes in three distinct forms. One is direct taxation via the income tax or federal excise taxes or even sales and property taxes at the local level. Another form of taxation is the issuance of debt. The government goes to the capital markets and borrows the money it needs to fund itself. The government is delaying direct taxation, but we can measure it by the line item expenditure of interest on the debt. The final form of taxation is inflation. A full discussion of inflation will need an entire post. All we need to focus on here is that it is the shifting of resources from the productive economy to the government and therefore a tax. It is a very hidden and subtle tax, which is why governments use it so frequently. You cannot have any amount of government spending without spending imposing a cost (tax) upon the productive economy.
Investment Strategy Fallacies
One fallacy is as I discussed above the idea that there is a difference between spending and taxes. The second fallacy is that government spending can occur without an increase in taxation. Imbedded in this fallacy is the notion that the debt or even inflation does not matter because “we owe it to ourselves”. Proponents of this view also believe that this government spending will provide employment that is not otherwise available. The final argument made by these advocates is that government spending will add to the wealth of the economy. Of course, the government intends to go beyond normal expenditures and keep otherwise insolvent businesses intact or to invent projects that will “create” employment and “wealth”.
The reality is quite different. The money that the government spends on various projects or directs toward pandemic afflicted businesses helps those who receive it. If the government builds a bridge, then bridge workers get work. Yet, this money comes from taxes, one way or another. A billion spent on a bridge is a billion that the taxpayers do not have. They cannot spend that money on things they valued more than the bridge. Every public job created means a job destroyed or not created somewhere else. At best there is simply a diversion of jobs from one sector to another. Yes, the government built a bridge, but businesses cannot build other things as a result. This is just as true for any public work. If the government builds or subsidizes low income housing, then consumers cannot spend that money on something else. If the government funnels money to pandemic stricken businesses to keep them afloat then the government prevents that money from producing goods and services that better satisfy consumer demand. Not only is there no net job creation in all of this pandemic policy but you ossify the economy and create a static social and economic environment. The effects of government spending are very visible, but the costs are usually not.
Taxes Discourage Production
The fallacy among many is that taxes have no actual effect on economic behavior. The pro-government folks simply treat taxes as a bookkeeping entry, a simple transfer from A to B with no knock-on effects. The reality is that not everyone pays the same percentage of taxes. Typically, a small percentage of earners pays most of the income taxes. However, taxpayers will and do respond to the incentives that taxation creates.
Say a business loses 100% of every dollar it loses in the marketplace but only gets to keep 60% of every dollar of profit, then its policies will be affected. This business will not expand its operations or only expands those operations that are less risky. It will not invest in newer machinery and it will end up developing products more slowly than otherwise. Consumers are prevented from getting better and less expensive products and subsequently real wages are held down.
Personal taxes have the same effect. If an individual loses 100% when they lose but only gets to keep 50% when they profit, then they will avoid risk. This policy will slow and in fact shrink capital formation. This policy will soon slow job creation and discourage new business formation. In our current environment the government will slow the movement toward a new post-pandemic reality and retard the recovery.
The government will produce all of these same effects (and even worse ones) if the form of taxation is inflation. As I indicated, this requires a whole separate post on the mechanics of inflation.
Investment Strategy Options
What then should an investor do? One possibility is that an investor can implement an investment strategy that takes into account government spending and tax policy. This will mean that investors will need to dive deep into the various sectors and pick winning sectors based upon where the government will spend the taxpayer’s money. Another approach is to develop an investment strategy that finds the companies that will benefit from government largesse. There is good reason to avoid this type of an investment strategy. First, it entails a lot of work. Using the Cake Investment Plan, you only need 15 minutes a month and no eye straining research in front of your computer. Second, using this investment strategy will entail a great deal of single company risk. There is simply no reason to take that kind of risk. It is far better to follow The Cake Trend Identification Line and invest in a low-cost broad-based index fund. If you go with an investment strategy that is low-cost, simple, rules based and emotionally attainable you will have a better chance of generating solid returns without having to pick the winners and losers from government tax and spend polices. It is important to remember, though, that all of these policies will have a negative effect on the wealth of the economy and therefore on your own pocketbook as well.