This is one of the most discussed phenomena, especially in
countries where government spending plays a crucial role for economic growth
and development.
The government incurs heavy expenditure on the development of
social and economic infrastructure like roads, railways, bridges, schools, etc.
Normally, for any government, major sources of funds are
1) Taxes
2) Borrowings
Generally, when the government resorts to expansionary fiscal
policy or when there is a developing country which is running a fiscal deficit,
the government faces scarcity of funds because of increased expenditure
requirements.
Thus, the government will do either of two things.
1) Increase taxes
2) Increase borrowings
1) Increase in taxes may result in an increase in the government
tax receipts, but an unwelcome outcome can be decreased spending from the
private sector. Because increased taxes will result in less disposable income
in the hands of people and firms, which will lead to decreased spending
resulting in slowdown of economic growth.
2) Increase in government borrowings via issuance of treasuries
may lead to an increase in interest rates in the economy. Increased interest
rates in the economy will lead to a decline in private capital expenditure as
companies will be reluctant to raise funds at higher interest rates, thus again
impacting economic growth.
Finally,
An increase in government spending funded via increased taxes
and increased government borrowings may lead to a decrease in private spending
and expenditure.
This phenomenon is referred to as the Crowding Out Effect.
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