Politics and the economy go hand-in-hand, as government decisions and legislation shape financial markets and overall economic growth, both directly and indirectly. This influence is mostly the result of laws and regulations that affect companies’ operations and, ultimately, their financial performance. In turn, changes in companies’ financial prospects shape investor sentiment and cause other kinds of ripple effects in the market.
In the following paragraphs, we’ll explore how politics and legislation influence the economy, highlighting key events and decisions that have significantly impacted stock market performance.
How does politics affect the economy?
Common sense and reasoning suggest that economics influences politics, given that parameters such as unemployment rates and inflation levels shape the political climate. After all, legislators and other politicians are more likely to enjoy greater public approval if they can claim credit for economic prosperity, which is why questions regarding taxation and legislative changes frequently dominate political debates.
The 2008 global financial crisis is a clear example of this, as it triggered political shifts that eventually led to the rise of numerous populist movements around the world.
While economics certainly influences politics, the reverse is also true: political decisions can directly shape economic outcomes too. With the power to make various legislative choices, governments are in a position to impact the economy and influence the distribution of wealth and resources.
In other words, the relationship between politics and the economy is rather complex: changes in one domain influence the other, creating a butterfly effect. Factors like technological progress and globalization further complicate the situation.
How do taxes impact the economy?
Tax changes often trigger noticeable economic behavioral patterns among individuals. In simple terms, tax increases can boost government revenue, but they often come at the cost of economic growth and mobility. Conversely, tax cuts tend to result in temporary revenue reductions but encourage long-term growth.
In more complex terms? While tax cuts can stimulate growth by giving workers more incentive to not only work but also save and invest, they can also reduce the incentive to engage in productive economic activities. That is, tax cuts may provide asset holders with windfall gains by subsidizing existing capital, undermining incentives for new investments.
According to a 2014 study conducted by William G. Gale and Andrew A. Samwick, if tax cuts aren’t met with spending cuts, they typically increase the federal budget deficit. In turn, this reduces national savings and raises interest rates, thus negatively affecting the investing climate. Consequently, the net impact of tax cuts on growth remains uncertain and depends on both the design of the tax cut and its financing:
“[…] tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving—and with it, the capital stock owned by Americans and future national income—and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”
– Gale and Samwich (2014)
The same study reports that empirical studies focused on these issues conclude that sustained tax cuts financed by deficits are likely to reduce, rather than increase, long-term national income. However, tax cuts paired with spending reductions can positively influence growth, but major tax cuts in the US, such as those in 1964, 1981, and 2001/2003, have typically been paired with increased federal spending rather than spending cuts.
Tax reforms
Reforms aimed at income tax restructuring are even more nuanced. Rate cuts by themselves can reduce the federal budget deficit when balanced by base-broadening, i.e., the expansion of economic activity subject to tax. They also lower the impact effective marginal tax rates have on labor supply.
One key takeaway is that not all tax reforms affect growth equally. Reforms that improve incentives, reduce subsidies, prevent windfall gains, and avoid deficit financing tend to have more positive long-term impacts on the economy. However, the same policies sometimes also require balancing efficiency with equity, as certain trade-offs can emerge in pursuit of economic growth.
How do interest rates affect the stock market?
The health of the stock market is often seen as a gauge of economic health investor confidence, both domestic and global. Interest rates are central to this dynamic.
Interest rates represent the price paid for borrowing money over a period of time. For borrowers, the interest rate is a borrowing cost; for lenders, it’s the fee received for providing capital.
Experienced investors tend to seek out healthy markets since only a few individuals can achieve profits in inefficient markets. For example, if banks offer higher interest rates to depositors, people may shift from stocks to savings, reducing stock demand and lowering prices. Conversely, if bank deposit rates rise, lending rates are also likely to increase, reducing the overall economic investment and further suppressing stock prices.
A 2009 study published in The International Journal of Business and Management supports the theoretical expectation of a negative relationship between stock prices and prevailing interest rates but finds the results vary by country. For instance, in Malaysia, there is no significant link between interest rates and share prices, but changes in interest rates negatively correlate with changes in share prices.
In Japan, on the other hand, a positive relationship was found between interest rates and stock prices, but changes in interest rates were found to negatively affect stock price changes.
Common law vs. civil law: Do they impact economic growth?
The Legal Origins Theory suggests that the legal foundations of a country shape its economic development. That is, societies rooted in different legal traditions have distinct legal structures, which in turn foster varying economic results.
A 2024 study published in the Statute Law Review explored whether enhancing the quality of legal reforms would foster a business-friendly regulatory environment and positively impact economic and financial outcomes. The findings indicate that countries prioritizing high-quality legal standards in reforms tend to cultivate a stable social and economic setting. Conversely, the absence of systematic improvements in legal rules and regulations hampers economic and financial performance.
These results challenge the common view that reforms focused on bolstering investor and creditor protections reliably lead to stronger economic and financial results. This suggests that such improvements alone are not sufficient. Additionally, the study observes that nations starting from lower baselines in 2006 advanced more substantially than those with initially higher scores.
What kind of impact do regulation and deregulation have on the market?
It is often said that regulations lead to fewer options, reduce competition, and result in inefficiencies within industries. Conversely, deregulation is believed to promote operational flexibility, encourage competition, and boost efficiency. However, regulatory reforms can sometimes yield unexpected outcomes.
A study by Nydia Macgregor and Tammy L. Madsen published in The Palgrave Encyclopedia of Strategic Management (2018) explores this idea and finds that changes in regulatory environments alter the range of strategic opportunities available to firms and influence competitive behaviors. The authors report similar studies present several key findings in the area.
For one, deregulation effectively “resets” an industry’s competitive landscape, which creates a stage similar to the early stages of development. Secondly, performance heterogeneity differs between new entrants and incumbents in a deregulated market. And finally, profit advantages secured by new entrants under deregulation are more likely to be less durable than those of incumbents.
For example, a 2002 study published in the Strategic Management Journal on the US airline industry over a decade before and after pricing deregulation and entry showed greater performance variation among new entrants than incumbents post-deregulation. That is, incumbents maintained relatively stable performance across regulatory changes.
Macgregor and Madsen remind that other studies reveal that large new entrants adjust more slowly to deregulations compared to large incumbents. Conversely, small incumbents appear to adapt more slowly than small entrants. This implies that a firm’s history under previous regulatory conditions can constrain its ability to adapt to new frameworks. Nevertheless, large companies often maintain a competitive edge.
Key historical moments that moved the stock market
Investors closely monitor the government because political changes, geopolitical events such as wars, and other events are known to cause significant market swings, as history has repeatedly shown us. Below are three important moments in recent history when political developments triggered major stock market fluctuations.
#1 Kennedy Slide of 1962
The Kennedy Slide of 1962 — or the Flash Crash of 1962, as it is often called — refers to the steep stock market decline that took place between December 1961 and June 1962, during John F. Kennedy’s term. After decades of steady growth, the market hit a peak at the end of 1961, only to plummet in the first half of 1962, likely due to concerns about rising interest rates and stock valuation skepticism. The S&P 500 dropped by no less than 22.5%, and the market struggled to stabilize until the end of the Cuban Missile Crisis.
#2 Brexit
In 2020, the UK left the European Union. Leading up to the vote, polls suggested the majority would vote in favor of remaining in the union, so the market went with the flow. However, when it became clear that Brexit would indeed happen, the S&P 500 fell by 6.5% in two days. The market quickly rebounded as investors reassessed the impact, but the downturn is a good illustration of how quickly the market can change when politics are involved.
#3 The 2016 Trump Rally
The uncertainty surrounding Donald Trump’s first presidency shook the market, and Dow futures went down by 900 points on the very election night. The initial overnight losses reversed dramatically when the markets opened the next day. On November 9, 2016, the Dow Jones Industrial Average closed up 257 points (1.4%), marking the start of a post-election rally.
Investors anticipated that Trump’s tax cuts and pro-growth policies would prop up the economy, and the S&P 500 went up by 14.2% from November 7, 2016 until the end of the year.
#4 COVID-19 market crash
In early 2022, the S&P 500 went down by 34% in just over a month due to the economic uncertainties that came with the COVID-19 pandemic. This was the sharpest decline in history.
Conclusion
To sum up, politics and legislation shape economic outcomes and influence the stock market in a highly intricate way. Tax reforms, regulatory changes, and other political shifts have far-reaching consequences on business performance and investor confidence, although fundamentals remain the primary driver of market performance.
By understanding the dynamic between politics and the economy, investors can gain a lot of insight into the ways political developments can either stimulate growth or cause market downturns. In turn, this knowledge can help them to navigate the market better and learn how to respond to market changes in times of political uncertainty.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs
How do politics impact the economy?
Most of all, politics influence the economy through monetary and regulatory policies. For example, stricter regulations can affect some companies’ operational costs and ability to deliver certain products and services, which impacts employment, inflation, and the overall economy, as well as investor sentiment.
Does the president control the stock market?
No, the president does not control the stock market.
What are some key historical events in politics that impacted the stock market?
Some key historical moments in politics that impacted the stock market include the Kenedy Slide of 1962, Brexit, the 2016 Trump Rally, and the COVID-19 pandemic.
How do legislative changes affect the stock market?
Regulatory changes can increase operational costs for companies, impacting profits and, thus, stock prices.
How do elections affect the economy?
Yes, elections often influence the stock market because markets react to expected changes in taxation and market regulation.
How does geopolitics affect financial markets?
Geopolitical events such as wars and global pandemics can disrupt trade, supply chains, and investor confidence, which can affect stock prices.
