Crowding out occurs when expansionary fiscal policies cause interest rates to rise or taxes to increase, thereby reducing private spending, particularly investment. This article attempts to analyze if the enormous U.S. Government spending plan will cripple the private sector growth and if the economy will perform way below its potential output as a result of the Government overspending.
There are several ways in which increased Government spending can lead to the private sector cutting back on its spending and expansion. To analyze each of these factors we need to understand how the Government gets money to fund its spending programs. The alternatives for the Government are few and easy to understand.
- The Government will increase taxes for individuals and corporates which will result in higher revenue for the Government. The Government can then fund its excess expenditure using these receipts.
- The Government can borrow money by selling Government bonds. These bonds can be sold to corporates in the country or to other countries.
- The Government can monetize debt. In this case, the money is not received from any of the above two sources. Money is just printed (created out of thin air).
With the sources of funds for increased Government spending clear, we now look into the impact of each on the private sector and also on the consumer in general.
Impact of Higher Taxes on Private Sector
The Government might chose to raise taxes in order to fund its increased expenditure. In this case, the corporates have to give higher taxes on their profits which leaves them with relatively lesser amount to spend on their growth and expansion.
Higher taxes on individuals can also have a negative impact on the private sector. Higher individual taxes will cause the disposable income for an individual to fall. This in turn will impact their spending decision. Any decline in consumption directly impacts the private sector growth.
So if the Government chooses to go for higher taxes in order to fund their spending, they might be doing more harm then good to the economy in general.
Moreover, we all know how efficient the Government sector is as compared to the private sector. So it would not be difficult to determine the direction of the economy of a country where the Government is getting bigger and the private sector is shrinking.
Impact of Government Borrowing on the Private Sector
If the Government sells its bonds to the private sector then its sucking out liquidity from the private sector and utilizing it to fund its spending. This has a direct impact on the growth and investment plans of the private sector as they has lesser funds in place for their growth.
However, even if the Government borrows funds from other countries, it impacts the growth of the private sector.