There are two looming issues on the fiscal policy front in the U.S. today. One is spending cut. The other is tax cut. For the first one, the House just rejected a bill to extend the benefit to long-term unemployment. Also, state governments are planning more spending cut in their states. Regarding the tax cut, it seems that the Bush era tax cuts will likely be extended before the end of this year.
Cutting government welfare expenditure is essential to reduce fiscal deficits. However, its short term cost could not be higher today. Chart 1 shows the three-month moving average of the percentage of personal consumption to the personal disposable income in the U.S. This percentage measures the consumer’s confidence in economy. The latest recession had brought the number from 95% in 2005 to below 90% in 2009. Currently, consumers only spend about 92% of their disposable income every month, the ratio that was common between 1993 and 1998. It shows that consumers are still very cautious toward spending money. Their confidence for the recovery is fragile at best.
Chart 1. 3-Month Moving Average of Percentage of Consumption to Disposable Income
But if we look at the percentage of wage, transfer receipts, and dividends, interests and rents to personal income over time (Chart 2), it is clear that the shares of both wage and dividends, interests, and rents are smaller than before recession. It is the transfer receipts that make up the lost income of the U.S. households.
Chart 2. Shares of Wage, Transfer Receipts, and Dividends, Interests, and Rents to Personal Income
Most of the transfer receipts come from the government, through tax revenue. Chart 3 compares shares of individual income tax payments and transfer receipts in personal income. The tax payment as a percentage of personal income is already the lowest after 1985, while the transfer receipts are the highest in history. The gap between individual income tax payments and transfer receipts expanded dramatically during the recession. Between 1998 and 2001, individual income tax payments used to be greater than transfer receipts. Now the gap is roughly 9% of personal income, almost the highest level after 1985. The big part of this shortfall now is funded through the fast growing U.S. government debts.
Chart 3. Shares of Individual Income Tax Payments and Transfer Receipts to Personal Income
If we strip the government debts from the personal income, then the ratio of consumption over non-borrowed income is totally different from what we see in Chart 1. Chart 4 presents the ratio of consumption to the ex-debt income. Without government debts-funded transfer receipts, the U.S. households right now already spend more than 90% of their personal income, almost the highest ratio after 1985. There is little room for the U.S. households to provide additional demand if the government handouts are cut off.
Chart 4. Shares of Consumption to Personal Income ex Government Debts
The job-benefit bill rejected by the House costs about $12 billion, less than 0.1% of current personal income. This money, as most of the transfer receipts, goes to the low income population. Tax cut extension will increase the disposable income for the high income population. The low income population tends to spend a larger share of their income than the high income population. A tax cut extension combined with a welfare spending cut (if there is any) to offset the reduced tax revenue will boost the stock market first, since the high income population own most of the U.S. equities. But in the longer term, lower consumption growth, persistent gap between tax payments and welfare payments, and reduced aggregate demand will be factored in the expectation and bring down the equity and bond prices.
Disclosure: no position