Many economists argue that the government should aim, as a policy objective, to minimise the level of government borrowing and should not increase its spending if this means borrowing to do so. If the government borrows heavily, it will have to compete for funds with private sector firms, which want to borrow to invest themselves. This competition for funds will push up interest rates. Higher interest rates mean that firms will be less willing to invest and individuals may even be more reluctant to borrow to spend. This process is described as government expenditure 'crowding out' private borrowing. In its most extreme form, an increase in government expenditure will lead to an equivalent fall in consumption and investment (because of the higher interest rates) with the result that aggregate demand does not increase at all.
Economists debate how significant the effect of crowding out is and, as with most things, they rarely agree! (Keynesians generally argue that an increase in government spending, through the multiplier process, will crowd in private consumption and investment).
If the problem is one of unemployment, changes in taxation and particularly government spending may have a significant impact on the level of national income through the increase in aggregate demand that they cause. Fiscal policy therefore may be very effective in reducing demand-deficient unemployment. (N.B. For HL students only, the effectiveness of fiscal policy in combating unemployment may be explained through the operation of the multiplier effect. This is dealt with in the HL extension section that follows).
Fiscal policy may also succeed in shifting the LRAS curve to the right, increasing real output and reducing the rate of inflation. This may work via greater government spending on education and training and tax cuts, which improve incentives to work and invest.
As will be seen in Section 2.3, fiscal policy may be used to alter the distribution of income and wealth within an economy. Greater emphasis on direct, progressive taxes and benefits to the less well-off make the distribution more equal. The opposite effect will be achieved through a shift towards indirect, regressive taxes and cuts in benefits for the less well-off.
Section 2 of the course showed how fiscal policy can be used in a selective way, for example, to:
- Increase consumption of merit goods through subsidies and direct government provision
- Decrease consumption of demerit goods and imports through taxation
- Increase consumption of public goods