Subject – Indian Economy
GS Paper – 3
Topic-
Fiscal Policy and Taxation system in India
Sub-Topic- Crowding out effect
Relevance – For Prelims as well as Mains
Crowding out refers to a process
where an increase in government spending leads to a fall in private sector
spending. This occurs as a result of the increase in interest rates associated
with the growth of the public sector.
If
government spending increases, it can finance this higher spending by:
1.
Increasing
tax
2.
Increasing
borrowing
Impact of higher government
spending on aggregate demand
1.
Increasing borrowing
·
If the government increases borrowing. It borrows
from the private sector. To finance borrowing, the government sell bonds to the
private sector. This could be private individuals, pension funds or investment
trusts.
·
If the private sector buys these government securities
they will not be able to use this money to fund private sector investment.
Therefore, government borrowing crowds out private sector investment.
2.
Increasing tax
·
If
the government increases tax on the private sector, e.g. higher income tax,
higher corporation tax, then this will reduce the discretionary income of
consumers and firms.
·
Increasing tax on consumers will lead to lower
consumer spending. Therefore, higher government spending financed by higher tax
should not increase overall AD because the rise in G (government spending) is
offset by a fall in C (consumer spending).
3. Social Welfare-
·
Crowding out may also take place because of social welfare, indirectly. When governments raise
taxes in order to introduce or expand welfare programs, individuals and
businesses are left with less discretionary income, which can reduce charitable
contributions.
· In this respect, public sector expenditures for social welfare can reduce private-sector giving for social welfare, offsetting the government's spending on those same causes.
For Practice Question of crowding out effect Click here
Comments on “Crowding out effect- Indian Economy , Fiscal Policy and taxation system”