Monthly Insights
Economic and Market Views
Jason D. Pride, CFA
Director of Investment Strategy
The Election:
In Search of the Optimal Fiscal Policy
I was working on a flat tax proposal and I accidentally proved there's no God.
— Homer Simpson upon removing a crayon from his brain¹
Summary
•The upcoming election is as much about how we address fiscal issues as it is about the pace
of the remedy; at the center is the debate over taxes and the size of government.
•Considerable academic research has been conducted to suggest there is actually an
“optimal” size of government that produces and sustains superior economic growth.
•This optimal solution requires a more balanced approach of higher taxes and less spending
than currently presented by either party’s election platform.
•Pending Presidential and Congressional elections continue to delay resolution of our nation’s
fiscal issues, making for a nail-biting year-end.
•In light of ongoing macro and political risks, we advise that investors maintain an emphasis on
the middle of the risk spectrum with a bias toward protection.
The Election: Near-Term and Long-Term Effects
Last month we argued for a fiscal solution that will spread the pain of deleveraging across multiple
years. Although this will constrain long-term growth, it will greatly reduce the economic burden
realized in any single year. We discussed also how the fiscal issues are shaping the campaign and
how the campaign, in turn, is further delaying resolution of the fiscal issues. While the debates,
conventions and stump speeches continue, January 1 draws nearer. On this date various tax cuts
will expire and the automatic sequester will go into effect, creating a meaningful headwind for the
U.S. economy (4 percent of GDP).
¹ The episode when Homer’s brain power increased dramatically following a medical procedure that removed a crayon wedged
into his brain.
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The Election: In Search of the Optimal Fiscal Policy
Fiscal Cliff
In addition to our near-term concerns over the delay of resolution, we should also consider
the longer term issues. We believe discussion of the election can be distilled to the traditional
debate between those favoring more taxes and larger government versus proponents of a
smaller, leaner government.
In Search of the Optimal Long-Term Policy
We will dare to explore the issue of government size from an economic perspective. Of course,
like Homer Simpson’s bumbling ways teach, this is not an easy subject to broach with a simple
explanation. Even a more complex explanation could be akin to trying to prove or disprove the
existence of God. But we will make a reasonable attempt.
The relationship between government size and economic growth has long been a source of
interest for economists. At the core is the relationship between public spending and economic
growth, a topic that has been theoretically debated and empirically tested in numerous studies.
While most studies interject a heavy political bias, we have found a few that provide a more
balanced perspective.
The Armey Curve: A Theoretical Framework
Many economists, dating back as far as Keynes, Friedman and Hayek, have proposed various
approaches to public policy, taxation and government spending. However, former U.S.
Representative and House Majority Leader Richard “Dick” Armey² put forth the most concise
² Richard Keith "Dick" Armey is a former U.S. Representative from Texas' 26th congressional district (1985–2003) and House Majority
Leader (1995–2003). He was an economics professor and Chairman of the Economics Department at University of North Texas from
1972 to 1983. He received PhD in economics from the University of Oklahoma.
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The Election: In Search of the Optimal Fiscal Policy
and understandable theoretical framework. The Armey Curve, as his framework is often referred,
illustrates an inverted U-shaped relationship between government size/taxation and economic
growth.
Armey Curve
This construct quickly passes the smell test of common economic theory. On the left side of the
graph exists the ‘no tax/no government’ extreme, which leads to the suboptimal outcome of
anarchy and the absence of law, organization and a collective infrastructure. On the other
side is the theoretical extreme at which point taxes become so burdensome that economic
growth is stymied. This occurs through numerous channels, including a labor force deterred
from pursuing additional money-earning opportunities, inefficient allocation of capital and
resources by government organizations (instead of free markets) and increased potential for
public sector corruption. At the heart of the theory is economic efficiency. For what projects
and services is the government the more efficient purveyor? When are free markets better?
What tax level discourages the marginal worker?
Academic Support, Not Just Political Rhetoric
Being intellectually honest and curious people, we are loath to accept a politically-borne
construct. However, Armey’s theory is academically supported by economic studies such as
those of Martin Feldstein, professor of economics at Harvard University and President of the
National Bureau of Economic Research. Feldstein’s findings hinge on two key conclusions:
taxpayers have a behavioral response to tax law changes and economic efficiency losses (or
deadweight losses as he calls them) result from sub-optimal tax policy design³. He is a long-
³ Feldstein, Martin. 2008. Effect of taxes on economic behavior. National Tax Journal 61(1): 131-139.
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The Election: In Search of the Optimal Fiscal Policy
time advocate of reforming the revenue estimation process used by the Congressional Budget
Office and other budgetary organizations to better reflect the behavioral reactions of taxpayers
to policy changes.
Many economists have adopted Representative Armey’s framework and continue to search for
the optimal level of government involvement. Two economists, Francois Facchini and Mickael
Melki, conducted a long time-series analysis of France’s relationship between government
size and economic growth between 1871 and 20084. A visual display of their results, shown
below, confirms the inverted U-shaped relationship. Since their analysis was limited to a single
nation, they relied on other similar studies to verify their conclusion and provide comparisons.
An inverted-U relationship between government spending and economic growth appears,
but there is a wide range of potential error in the estimation of the optimal tax rate. This is an
important point, one we will return to shortly.
Growth and Government Size in France (1930-2009) (10 year mean)
Kristof De Witte and Wim Moesen5, conducted one of the most robust analyses. This study not only
confirms the existence of an inverted-U-shaped relationship but further estimates the optimal
government involvement levels for 23 countries in the Organization for Economic Co-Operation
and Development. The study also recognized and adjusted for many differences between
nations, including population density and growth rate, urbanization, openness of economic
and capital markets and family size (which biases countries to need a larger welfare program).
On the next page, the results of this analysis show that most countries maintain a government
sized in excess of the optimal level. Where Italy and Greece appear relatively far away from
their economically optimal level, more prudent nations such as Germany and even the U.S. are
closer but still over the line. New Zealand is the only nation with room to spare.
Facchini, Francois and Michael Melki. 2011. Optimal Government Size and Economic Growth in France (1871-2008): An Explanation
by the State and Market Failures. Silvaplana Worshop on Political Economy 2011.
5
De Witte, Kristof and Wim Moesen. “Sizing the Government.” Public Choice 145 (2010): 39-55.
4
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The Election: In Search of the Optimal Fiscal Policy
Empirical Evidence: How Close Are We Now?
Size of public
sector
Long run optimal size
Change in long
run size
Australia
38.0
36.9
-1.1
Germany
46.7
43.0
-3.7
Greece
46.0
38.8
-7.3
Italy
47.1
36.9
-10.2
New Zealand
40.1
42.4
2.3
United States
35.2
32.0
-3.2
Average*
45.0
41.2
-3.7
*Average of full study sample of 23 OEC countries.
Source: De Witte, Kristof and Wim Moesen. "Sizing the Government." Public Choice 145 (2010): 39-55.
Data excerpts from Table 1.
So, how should the U.S. government react? Who is right and wrong? From an economic
perspective, it appears a preponderance of academic evidence supports the downsizing
of government spending. Updating these studies would stretch these results even further.
For instance, adjusting for the growth since 2008 brings the U.S. government spending rate
(including federal, state and local) to 38 percent of GDP. Although this figure is slightly distorted
by cyclical factors, it is well above the ideal 32 percent level. While this would appear to favor
the Republican platform of fiscal conservatism through spending cuts, the below graph shows
that decreased spending is only part of the solution.
Federal Government Revenues & Outlays
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The Election: In Search of the Optimal Fiscal Policy
Through the lens of tax collection as a percentage of GDP, the picture changes rather
dramatically. For a country with an outsized deficit gap such as the United States’, tax collection
is near an all-time low as government spending is near an all-time high. Tax increases, not tax
cuts, are likely necessary to restore our fiscal equilibrium. As a result, we conclude that neither
party’s platform provides the perfect solution. Instead, we advocate for a more balanced
approach over the long-term.
But the Conclusion May Also Depend Upon What You Are Trying to Optimize
Some studies suggest there is more to the purpose of government than just economic
optimization. In fact, many recognize that optimal economic growth may not coincide with the
government’s intended welfare of the average person, possibly overly concentrating wealth in
a select minority of the population. Others suggest that economic growth is simply one of the
goals of government, along with economic mobility (primarily through education), health and
public infrastructure. These “other” goals are not effectively captured in nearer-term growth
statistics, making the act of optimizing government’s efficiency more difficult than the simpler
economic optimization analysis discussed above. Political leaders are constantly challenged to
strike a balance—a laissez-faire policy when markets function favorably and intervention when
free markets do not support the common good. Nevertheless, the above discussion provides
a theoretical backdrop from a pure economic perspective. We must recognize that by taking
into account the other goals of government we may fall short of this ideal economic scenario.
Or perhaps, like Homer Simpson, we will simply prove or disprove the existence of God.
Election Update: An Edge to Obama
Last month we also introduced two competing predictors of the upcoming election, a shorterterm one6, based on state polls and electoral votes, and a longer term one7, based on empirical
evidence that suggests presidential elections are referendums on the incumbent party. While
the longer-term predictor would argue that President Obama is fighting an up-hill battle, nearerterm state polls indicate his chances are much better. Below we introduce yet another and
much simpler perspective on the upcoming election.
InTrade.com is an online prediction market where members effectively wager on the outcome
of various upcoming events, including political elections. The current market price for a contract
that pays $10.00 if President Obama is re-elected is currently changing hands at approximately
$6.50, indicating a 65 percent probability of re-election. Interestingly, from the chart on the
next page, it appears that at no time during 2012 has his chance of re-election dipped below
50 percent. While these online prediction markets have not been perfect predictors of past
elections, they can provide effective estimates of the likelihood of the upcoming election.
6
7
Source: RealClearPolitics.com
The Bread and Peace Model is a regression of the share of the electoral vote received by an incumbent based on two factors:
the weighted-average growth of real disposable personal income and cumulative military fatalities owing to deployment of
American armed forces in foreign wars. The model was created by Douglas A. Hibbs, Jr., a professor of economics at the University
of Gothenburg, also formerly a Harvard professor and MIT instructor.
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The Election: In Search of the Optimal Fiscal Policy
Online Election Odds Favor Obama
A 65 percent probability does not guarantee President Obama’s success but is a relatively
fair estimate of his chances based on the latest online transaction. If these predictions prove
accurate, the policy direction of this nation will likely continue to lean toward higher levels
of taxation and spending and further from the “optimal” economic outcome. A re-elected
President Obama will likely pursue an agenda intended to optimize more than just economic
growth and investors should manage their expectations accordingly.
Investment Strategy Amid Sub-Optimal Fiscal Policy and Election Uncertainty
Independent of party affiliation, we believe the next President will be required to push the U.S.
economy through a deleveraging period which should restrain economic growth. The election
outcome may also influence how fiscal restraint is implemented (balance of tax cuts/spending
reductions, reform of tax code or entitlements). As suggested earlier, neither political platform
aligns with the academically-driven optimal fiscal policy. It is possible that the ongoing political
divide will force compromise, resulting in a middle-of-the-road outcome. Ironically, such a plan
may more closely align with the “optimal” level. We are, however, hesitant to predict or invest
on the presumption of this outcome.
Presently, our greatest concern stems from the delay in resolution caused by the election season.
As December’s Congressional deadlines approach this will likely cause consumer, corporate
and investor angst. In recognition of this and other inputs (e.g., continued softness in our
economic leading indicators), we continue to favor a more protective investment allocation.
We believe the risk of policy disappointment remains high and resulting economic sluggishness
will manifest in slower earnings growth and more modest and volatile equity gains.
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The Election: In Search of the Optimal Fiscal Policy
We also continue to believe the best opportunities are found in the middle of the risk spectrum,
away from the typical hunting ground of traditional investors. While the most protective assets
are priced to underperform inflation and traditional equities will likely remain volatile and fall
short of past return experiences, investments in the middle are better suited to deliver superior
risk-adjusted returns. Opportunities in this space include lower risk equity portfolios (high quality/
low volatility), high yield bonds, emerging market sovereign debt, option-selling strategies (e.g.,
cash-secured puts and covered calls) and hedge funds (although we are quite selective in this
space). Our goal is to continually deliver respectable returns on client assets, steering away from
the quagmire of this deleveraging period, protecting portfolios from the inevitable financial
and economic shocks that remain.
Combined (Adaptive & Long-Term) Equilibrium Model
Projected 10-Year Risk-Adjusted Returns by Asset Class
Monthly Insights is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's
clients and friends and is not intended as personalized investment advice. It reflects opinions based on market and other conditions
as of the date of publication, which are subject to change. Various risks and uncertainties mean that actual outcomes and events,
including portfolio performance, may differ materially from what is contemplated herein. This presentation is not intended as an offer
or solicitation for the purchase of any investment product or service. Actual investment decisions are made in light of all applicable
circumstances and may differ from the strategies or products mentioned here. Clients are encouraged to discuss the applicability of
any topic or view contained in any Glenmede publication with their Glenmede representative.
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