According to the general equilibrium models of contemporary macroeconomics, tax policy could crowd out private activity in the credit market. This argument also goes the other way: Contraction Policy could allow for increased private activity in the credit market. This phenomenon is sometimes referred to in the literature as “cluttering”.

Understanding restrictive fiscal policy

Fiscal policy refers to the spending and taxing habits of a government. There are two types of fiscal policy stance: restrictive and expansionary. Think of restrictive policy as anything that directly reduces government deficits or increases surpluses. Expansionist policy involves activity that directly increases deficits or reduces surpluses.

After a tax hike, the government balance sheet shows more income. Similarly, a reduction in spending is restrictive because it reduces spending. According to the standard measurements of gross domestic product (GDP), the restrictive fiscal policy seems to reduce total output. Taxes tend to reduce private consumption just as spending cuts reduce public consumption.

Understanding Eviction and Eviction

Suppose the federal government increases its tax expenditures by $100 billion in a given year. If the taxes are politically unpopular, the government normally finances the additional spending through borrowing. The federal government borrows money by issuing US Treasury bonds. In this case, the government is issuing $100 billion in treasury bills. This directly absorbs $100 billion from the credit market, money that could otherwise have been spent on other investments or consumer goods. Public issues take place by crowding out potential private issues.

Moreover, an influx of governments debt securities affects interest rates and asset prices. If individuals are encouraged to increase their savings to buy public debt, the real interest rate tends to rise. When real interest rates rise, it is more difficult for individuals and small businesses to obtain loans.

Similarly, a decrease in government borrowing could leave more money for private investment. Less pressure on interest rates means more room for small borrowers. In the long run, less government spending often means less tax, further increasing the pool of funds available for private markets.

If the government’s restrictive fiscal policy leads to surplus, the government can act as a creditor rather than a debtor. The effects of this are no more certain than the effects of the budget deficitbut all economists agree that it will have some impact.

Two types of stacking

Some economists have argued that, under the right circumstances, expansionary government policy could produce a crowding-out effect instead of a crowding-out effect. If, as Keynesian economists propose, an increase in aggregate demand creates economic expansion, so businesses find it profitable to increase capacity. This stimulation of the markets, called induced investment, could be stronger than the crowding out effect.

This is a very different argument from the traditional ripple effect, which results from a restrictive fiscal policy. Each argument has its pros and cons. To complicate matters further, some economists admit a crowding-out effect but disagree on its magnitude and long-term effects.

(For related reading, see “What is fiscal policy?“)