How does the government economic policies impact my personal finances? 

What is fiscal policy?

Very simply, government earns money through different taxes and spends money on different budget items. The policies surrounding how much the government decides to tax its citizens and how and where to spend the money is basically a fundamental element of fiscal policy. The difference between its income and expenses is essentially a surplus or a deficit (note we don’t use the term profit or loss like in a company). So what happens when the expenses are more than the incomes – like in the case of most governments? They basically borrow money to cover the difference. This is the debt of the country and forms the other part of fiscal policy. So, in summary, fiscal policy is 3 things:

1. How much the government decides to tax its citizens (impacting its revenue)
2. How much and where to spend the budget money on? (impacting its expenses)
3. How much and where to borrow money from? (or) how much and where to spend the surplus on?

Taxation

Most governments in the world’s primary revenue source is taxation. Unless you are an oil rich middle eastern country.  There are a wide variety of taxes that the government can impose on its citizens but the most prominent of them are income taxes. I have talked about US income taxes a fair amount on my blog. But the government also collects other forms of taxes. Some of these taxes tend to get collected at the local level like property taxes and sales taxes. In the US, payroll taxes are an important part of government revenue (they are not considered income taxes though people with W2 incomes will see that deducted from their paychecks and might consider them income taxes).

So the government’s decision on how much to tax its citizens has a critical impact on our personal finances. Governments can decide to increase, decrease tax rates, tax credits, offer tax relief on certain expenses, investments. More often than not, changes in taxation are the most direct implication to our personal finances. The question everyone likes to ask in the US is where will taxes go in the future. A lot of experts believe that in order to control the deficits and due an unfavorable demographic projection, the government will eventually have no choice but to raise taxes in the future.

Ultimately, we don’t control this and trying to predict this might not be a worthwhile exercise. However, making smart tax location decisions for your assets as you plan for your retirement will be important. Understanding tax implications of your investments and income and planning accordingly is a prudent financial move. I have talked about some of this in some blog articles but wont go into much detail here as it is not in the scope of this article.

Government spending

You may wonder why this impacts our personal finances in any way. If the government decides to spend money on upgrading infrastructure or on defense spending, why does that impact us? In many ways, it does not have a direct impact. However, the decision of the government on where and how much to spend the money can indirectly impact us. This is a bit of a debatable topic btw and economists around the world often sit on different ends of the spectrum on this. Government spending can be broadly categorized in the below 3 buckets:

1. Fiscal Stimulus spending – Most recently in 2020, we saw governments around the world spending a tremendous amount of money on sending stimulus checks to individuals directly as well as providing unemployment benefits and other income protection programs. Obviously, this kind of spending means you can potentially get extra cash in your hand. The governments did this to protect people from the negative impact of the pandemic. It’s a different matter that there is a lot of debate about whether this spending was excessive and caused inflation.
2. Mandatory spending – most governments may have mandatory spending budget items that they cannot necessarily flex due to laws. In the US, this includes spending on Medicare (Healthcare for seniors), Medicaid (healthcare for the poor), Social Security and a few similar items. Unless you are someone in those recipient categories, spending on these items don’t generally impact you directly. Paying interest on the borrowed debt is also considered mandatory for most parts.
3. Discretionary spending – this is where things get a bit more interesting. Traditional discretionary spending happens on items like defense. But this can also include decisions to spend on public works and infrastructure. Depending on the kind of spending, these can tend to have somewhat of an indirect impact on some of us. Increase in this kind of spending ends up having the same effect as pumping more money in the economy similar to monetary policy as I discussed in my article on “Why do I care about what the central bank does?”. Whether this benefits the economy or not depends on a host of factors. But governments try and do this to help expand the economy typically and/or because these types of spending need to be done since the private sector will not find it financially attractive to do so.

The US government has a really nice website showing a fair amount of detail on where the government spends it money and how much it spends in this site https://www.usaspending.gov/.

Government debt

I am not going to talk much about government surpluses here today because they tend to be rare (very few governments have surpluses today). So, lets talk about how governments tend to fund their extra spending. As I mentioned, they do it through debt. So where do governments raise debt from? Most governments raise money by issuing government securities (in the US, the Treasury does this through securities called notes, bills or bonds). So, who typically tends to be lenders to these countries?

1. Its own citizens – this is pretty common. A government can issue bonds that its own citizens will buy in return for a generally fixed and low risk return in the form of interest. The largest creditors to US debt is actually its own citizens.
2. Institutions – typically institutions like pension funds, endowment funds etc will all invest in government securities as part of their investment portfolio.
3. Other countries – Other countries can also buy these securities. US’s largest outside country debtors are Japan and China. They hold large amounts of US debt. They do this because they consider the US government safe debt and also because they can easily convert it to a stable currency like USD which is valuable. Of course, all this can change in the future.
4. Other government agencies – Ok, admittedly this was confusing for me. The government borrows money from itself? That’s a bit of circular logic, isn’t it? To me, this was the most confusing part. But without making this too complicated – there are some agencies like the Social Security Trust Fund that invest their extra reserves in government securities because this is considered safe debt.
5. The Central Bank – if you thought, the previous point was confusing, this is worse 😊. However, remember the article “Why do I care about what the central bank does?”. I mentioned how the central banks sometimes buy government debt through quantitative easing. Well, this is where it shows up. In effect, this is where the government is kind of ‘printing money’, or creating more money from scratch in the system. The US Fed buying US debt is a more modern phenomenon that dramatically ramped up following the 2008 financial crisis.

So the obvious question that should flow in all your minds as you read all of this is – can the government keep unlimited borrowing and growing the national debt? The answer you may be surprised to read is, it depends. It depends on who you ask and when you ask. As I mentioned, some economists on either end of the spectrum. But also, economists and politicians will give you a different answer depending on the current state of the economy. In 2020, most folks unanimously agreed providing some stimulus to the economy during the pandemic was needed. But as inflation started to increase in different countries, the views got more polarized.

So how does Government debt influence your personal finances?

Ok if you are with me so far, please stay with me for this next section. This is where I am going to try and explain some of the convoluted cause and effect relationships between the different parts of our economy. Lets examine the different ways this can impact you:

1. Unsustainable amounts of debt can create risk of default – In recent years, we have seen the example of Greece and Argentina. When the amount of debt becomes extremely high typically due to more spending, creditors will no longer be willing to lend money. This always leads to forcing the country to dramatically reduce its expenses and/or increase the taxes which impacts the common person in multiple ways. The US government has never defaulted and is considered a safe haven and hence, there have always been creditors willing to lend money. But it would be naïve to assume this will always be the case. If you were a citizen of Greece during the crisis, you were faced with massive unemployment, lack of basic government services and the list went on.
2. High debt can lead to creditors asking for higher rates  – Monetary and fiscal policy are intertwined in many ways here. If the central bank raises interest rates as part of monetary policy, the US government will need to pay higher interest rates to its creditors. Sometimes this can also be if the government defaults on any debt like it happened to Greece. So all this means the cost of borrowing for the average person will go up. In the US, the mortgage rates are tied to US treasury yields and as they go up, so do mortgage rates.
3. Higher amount of interest rates also mean fall in other asset prices – Think of it this way. When the interest rates increase, it creates a double whammy effect on companies. On one hand, it increases their cost of borrowing, and this causes them to increases prices in the market as well as conserve cash and invest less in the business (causing demand for the goods they buy to go down). On the other hand, this causes less disposable income for consumers thereby reducing demand for companies. All of this reduces profits and therefore stock prices of the companies. The opposite can be true when interest rates go down.
4. Ultimately high debt can lead to high inflation – Based on everything you read so far, it should be obvious to you that when a country borrows too much money to pump more money into the economy, you have a recipe for higher inflation. As I have mentioned before, a lot of experts believe this is the reason for the current high rates of inflation in the world in Aug 2022 at the time of writing this article. Everyone is feeling the pinch of inflation to their personal pocketbook at the time of writing this article.

So when do I know if the level of debt is bad? Economists around the world use a metric called Debt to GDP ratio. It basically looks at the overall debt of a country and divides it by the GDP (Gross Domestic Product – the value of all the goods and services produced in an economy). So debt growing in absolute numbers may not be the worst thing but if debt grows more than the economic growth then it tells you the government is borrowing more than it can earn. There is a good visual by the visual capitalist showing different countries debt to GDP ratio that is interesting to see: https://www.visualcapitalist.com/global-debt-to-gdp-ratio/

Concluding thoughts

Ok I don’t want to make your head spin any more. My goal was to help you understand the interconnectedness of the government’s economic policies to every one of us. The above discussion was vastly simplified and there many layers of nuance to the above topics. But I think it captures the essence of what I would like all of you take away from today. At the end of the day, connecting the dots between all this won’t make you a noble-prize winning economist but it will definitely help you with better personal finance decision-making.

Thank you for reading and I wish you success in your personal finance journey!

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.