The author is a visiting scholar at the Hoover Institution and senior economist at Berenberg Capital Markets.
As the Federal Reserve ponders how much further it needs to raise interest rates to lower inflation to its 2 percent longer-run target, it faces an unanticipated and not widely understood counterbalance: fiscal policy continues to stimulate economic growth, employment, and wages. The notion that fiscal policy is still stimulative is not captured by mainstream measures of fiscal thrust that interpret the downward drift of federal budget deficits as a percent of GDP as neutral or mildly restrictive. Reflecting this conventional Keynesian framework, Fed Chair Jerome Powell stated last year that fiscal policy was becoming restrictive, which proved misleading, and recently he suggested it was relatively neutral.
An alternative assessment reveals that specific government spending and tax policies are measurably stimulating government and business investment and boosting GDP. Specifically, the Infrastructure Investment and Jobs Act (IIJA) of 2021 is in the process of adding $1 trillion of government purchases into the economy, while the favorable lending and tax credits of the misnamed Inflation Reduction Act (IRA) and the CHIPS and Science Act of 2022 (CHIPS) are generating sizable increases in private business investment.
Standard deficit-based measures of fiscal policy capture the flows of government spending and tax receipts but fail to reflect the allocative and economic effects of these government programs. Yet that’s what fiscal policies do: they allocate and redistribute national resources and influence economic behavior and outcomes. The Biden administration’s intended purposes behind these legislative initiatives are to improve the nation’s infrastructure and fund the rebuilding of industrial manufacturing sectors in ways it deems appropriate—particularly to shift production and consumption toward renewable energy, to create well-paying jobs, and to increase the size and scope of the government. Combined, these initiatives represent the largest increase in government spending and funding of the nation’s infrastructure and industry since the 1930s New Deal.
History shows that the government has a poor track record of picking productivity-enhancing projects compared with market-determined private sector investments. While some initiatives in the recent legislation looks promising, many other costly initiatives will provide little lasting impacts. Regardless of whether President Biden’s industrial policies raise productivity or measurably improve standards of living relative to their costs—it’s far too early to make that assessment—they are decidedly activist fiscal policies that are currently adding materially to GDP.
From this angle, the mix of fiscal and monetary policies is working counter to the Fed’s objective of lowering inflation, as the Fed’s efforts to reduce inflation through raising rates and slowing aggregate demand are being partially offset by fiscal policy that is pumping up economic activity. It is important for the Fed to understand the economic effects of fiscal policies and consider the appropriate mix of policies.
The shifting focus on government and private investment
Fiscal policy reached its peak degree of stimulation with Biden’s $1.9 trillion American Rescue Plan in March 2021, the culmination of more than $5 trillion in federal deficit spending authority in response to COVID-19. This was by far the largest peacetime surge in deficit spending in history, amounting to over 25 percent of GDP. The massive income support quickly filled the gap generated by the pandemic and government shutdowns and fueled a robust recovery. A small but meaningful portion of the deficit spending that was authorized has not yet been put to work in the economy.
Federal budget deficits have fallen sharply from their peak with the surge in tax receipts generated by the strong economy and decline in pandemic spending, and the deficit/GDP ratio has continued to drift lower as a percentage of GDP. The following government policies continue to generate GDP growth:
- The Infrastructure Investment and Jobs Act of 2021 (IIJA) is generating sizable increases in government purchases, which have contributed significantly to increases in GDP and private sector activity in recent quarters and will continue in coming years;
- The direct government investments, tax incentives, and loan subsidies provided by the CHIPS Act and the IRA are generating a surge in private business investment in semiconductor and battery manufacturing facilities and other energy-related manufacturing centers, lifting overall business fixed investment; and
- State and local governments that saved most of the federal grants they received for COVID-related costs and have amassed an unprecedented cushion of savings have begun to spend, or in a few cases, lower taxes, and this is now stimulating economic activity.
Several characteristics of these fiscal initiatives are noteworthy. First, they involve sizable time lags between when the legislation authorized the increases in spending and when the spending actually flows into the economy and is measured in GDP. Second, government investment spending historically has substantially higher fiscal policy multipliers than government transfer payments. Third, so far, business investment responses to the tax incentives have far exceeded early estimates and government financing of the energy sector investment projects is expanding rapidly.
The ten-year spending authorizations for many of these initiatives and the open-ended tax credits suggest sustained economic stimulus for years to come. The stimulative impacts of these initiatives will be partially offset by the end of the student debt moratorium. This will reduce the personal income available for spending on other goods and services.
Along with these initiatives, although not traditionally considered fiscal stimulus, the cost-of-living adjustments (COLAs) of Social Security and other government entitlement programs that shield nearly one hundred million people from inflation are adding markedly to disposable personal incomes.
Government infrastructure spending
The Infrastructure Investment and Jobs Act (IIJA), enacted in November 2021, authorized approximately $1 trillion over ten years toward infrastructure projects. Its focus is investment in core infrastructure including improving roads and bridges, rail, transit, ports, airports, and the electrical grid, and it also prioritizes job creation. If the spending were spread evenly, a $100 billion rise per year would add significantly to GDP, between 0.4 and 0.5 percent in 2023. It has taken a while to gear up—identify projects, send out requests for proposals, and pick private contractors to do the work—but since the third quarter of 2022, government spending on a variety of infrastructure projects has ramped up and is adding significantly to GDP growth.
Of note, all government infrastructure spending authorized by the 2021 IIJA will be counted directly in GDP as government consumption and investment (G) as the money is spent. In contrast, government checks to individuals during COVID and transfer payments to Social Security beneficiaries are not counted in GDP until they are spent. Government purchases (G), comprising federal, state, and local government consumption (general operations like paychecks disbursed to military personnel and schoolteachers) and investment (government funding to build a bridge or schoolhouse) is generally government spending that “absorbs national resources,” unlike government payments to individuals like Social Security that transfer resources but do not absorb them. Prior to the pandemic, G was between 17.5 percent and 18 percent of GDP.
The government’s massive COVID-response cash distributions to households and businesses lifted disposable personal incomes, but it is well documented that a sizable portion was saved. As a result, the rate of personal saving soared and the fiscal multiplier of the government deficit spending was well below 1.0. Since then, as high inflation impinged on real purchasing power, households have been spending their cushion of savings, so the earlier government deficit spending is having a lagged effect, and the cumulative fiscal policy multiplier presumably is moving up toward 1.0.
G registered large increases beginning in 2022 Q3 and has risen 3.8 percent from 2022 Q2 to 2023 Q2. Even excluding federal defense spending, these government purchases have contributed nearly 20 percent of the rise in real GDP in the past year. Large increases in government investment are expected to continue. Spending on the IIJA infrastructure initiatives is at an early stage, and the Biden administration has the political incentive to stimulate the economy—and create high-paying jobs—before the 2024 presidential election.
Biden intended that the IIJA would focus on creating new well-paying jobs as well as improving infrastructure. His promise that the legislation would create one million jobs may have been a stretch, but nearly one-half of the IIJA is allocated to improving roads and bridges, relatively labor-intensive projects. With labor shortages already reported in construction, employment in construction for IIJA projects is already being felt. Moreover, the law requires all private sector contractors and their employees to be unionized, and all workers on the infrastructure projects must receive union wages and benefits. This will add to disposable incomes. Whether these government-financed increases in employment paying well above average wages have the knock-on effect of displacing workers from other jobs and occupations, or affect wages in other industries, is another issue.
Historically, government investment spending has had a larger fiscal policy multiplier than transfer payments. The longer-run multiplier depends heavily on whether the government-financed projects add to productivity. The ultimate economic impact of the IIJA is uncertain, depending critically on the infrastructure projects undertaken, but its cumulative impact on GDP is likely to be greater than 1.0.
The CHIPS Act and IRA stimulate private investment
The CHIPS and Science Act of 2022 authorizes spending of $278 billion over ten years on scientific research and development of technologies deemed critical to the US energy, artificial intelligence, quantum computing, and advanced manufacturing sectors. It has a particular emphasis on semiconductor manufacturing (Chart 1), with $52.7 billion allocated to chip manufacturing and $24 billion for tax credits to manufacturing.
Chart 1. CHIPS and Science Act spending 2022–26 ($billions)
Source: McKinsey & Co.
While the CHIPS Act is controversial, involving industrial policy that provides generous subsidies specific to the computer chip and other industries, its current measurable contribution to GDP is unambiguous. As shown in Chart 2, business investment in manufacturing facilities, particularly for semiconductors, in response to the tax credits has surged. The Congressional Budget Office originally estimated the 25 percent tax credit for the costs of building semiconductor facilities would cost $79 billion over its ten-year budget projection, with $48 billion of the amount in the first five years. But the spike in business spending on computer, electronic, and electrical manufacturing facilities has far exceeded expectations and contributed to the total increase in business fixed investment in the past year, and further increases are expected.
The CHIPS Act complements the stimulus provided by the IRA enacted in August 2022. The Congressional Budget Office estimated that the IRA would provide $499 billion in spending and subsidies through a mix of tax credits, grants, and loan guarantees for clean electricity and transmission and clean transportation, particularly electric incentives (Chart 3). The Wall Street Journal characterizes the Department of Energy’s subsidized loan program as “one of the largest outlays of taxpayer-financed industrial stimulus since the 1930s New Deal.” It is just part of the Biden administration’s industrial policies.
Chart 2. Manufacturing of computers, electronics, electrical equipment ($billions)
Source: Census Bureau/Haver Analytics
Chart 3. Summary of the Inflation Reduction Act
Source: Congressional Budget Office, September 2022
In response to the fiscal stimulus, business fixed investment has increased 4.6 percent in the year ended 2023 Q2, even as the Fed has raised rates by the largest amount in over forty years. Further increases supported by the CHIPS Act and IRA subsidies may continue to provide a powerful buffer against typical cyclical weakness in business investment. As with the IIJA, while the government spending on the CHIPS Act and IRA will have multiplicative impacts on economic activity in the shorter terms, its longer-run fiscal multipliers will depend critically on whether the investments increase productivity.
State and local government spending stimulates the economy
The federal government’s $5 trillion increase in deficit spending in response to COVID included $500 billion in grants to state and local governments to fund COVID-related needs, $350 billion of which were part of the American Rescue Plan. This was Biden’s first piece of fiscal legislation enacted in March 2021, when the robust economic recovery was already generating strong increases in tax receipts while the federal government was directly subsidizing the administration of COVID vaccines. With overflowing tax receipts, state and local governments saved most of their grants.
These savings are apparent in the surge in state and local government ownership of US Treasuries, which provided yields far above yields on bank deposits. As shown in Chart 4, state and local government holdings of Treasury securities jumped simultaneously with the federal grants and through 2022 Q4 had doubled their average pre-pandemic level, a $775 billion increase. This rise amounts to roughly 3 percent of GDP.
Chart 4. Estimated ownership of US Treasuries—state & local governments ($billions)
Source: US Treasury/Haver Analytics
It is highly unlikely that state and local governments have permanently increased their desired level of savings cushions. Just as the federal government’s generous cash distributions resulted in a surge in disposable personal income and a sizable cushion of household savings that have allowed consumers to maintain spending, state and local governments now have a savings cushion that will be used to fund spending increases (or in a few select situations, tax cuts) over the intermediate term. These initiatives will stimulate economic activity, with no direct impact on federal deficit spending or budget deficits.
COLAs and the end of the student debt moratorium
Cost of living adjustments (COLAs) have been part of the fiscal policy landscape for decades, designed to maintain the real purchasing power of beneficiaries by offsetting the impact of inflation, and as such they are not traditionally considered fiscal stimulus. Social Security benefits have been indexed to the Consumer Price Index (CPI) since 1974. Nevertheless, the 8.7 percent COLA for Social Security alone resulting from the 2022 surge in inflation is adding over $100 billion to nominal disposable income in 2023.
Almost all government entitlement spending programs are either directly or indirectly indexed to inflation, from pensions and the SNAP program to components of Medicaid and Medicare reimbursements. Combined, the COLAs will add approximately $250 billion to federal deficit spending this year—more than 1 percent of disposable income. At the same time, key provisions of the personal income tax system, including income tax brackets, are indexed to CPI inflation, supporting real take-home wages and salaries. These positive supports for disposable personal income and real purchasing power have been partially offset by the expiration of some fiscal payments tied to the pandemic emergency, such as enhanced SNAP benefits and the expanded child tax credit.
A moratorium on federal student loans that was initiated by the CARES Act in March 2020 and extended several times by presidential executive order is due to expire at the end of August, requiring borrowers to begin servicing their student debt beginning in September. Currently, total student debt outstanding is $1.1 trillion and the moratorium has saved roughly twenty million borrowers an average of around $250 per month, and is costing the federal government approximately $5 billion per month. (Separately, Biden’s executive order to forgive an estimated $500 billion in student loans was recently found unconstitutional by the Supreme Court.) The Biden administration has announced that it will be rolling out new initiatives to forgive some student loans and subsidize borrowers.
The resumption of student debt repayments later this year will have a sizable impact on borrowers, reducing their disposable income available to purchase other goods and services, but in the aggregate, this will involve a relatively minor offset to the fiscal stimulus provided by the IIJA, CHIPS Act, and IRA.
The IIJA, CHIPS Act, and IRA are fiscal legislation that is stimulating significant increases in government and private sector investment and thus boosting GDP, but this is not captured by standard fiscal policy measures based on the relatively stable deficit/GDP ratio. Spending for these sizable programs has been authorized for up to ten years. Their stimulus runs counter to the Fed’s rate increases aimed at slowing aggregate demand and lowering inflation. The Fed needs to build a more comprehensive understanding of the economic effects of fiscal policy beyond estimations based on mainstream deficit/GDP models.