HOW PUBLIC FINANCE AFFECTS THE ECONOMY

Government spending and taxation directly affect the overall performance of the economy. For example, if the government increases spending to build a new highway, construction of the highway will create jobs. Jobs create income that people spend on purchases, and the economy tends to grow. The opposite happens when the government increases taxes. Households and businesses have less of their income to spend, they purchase fewer goods, and the economy tends to shrink. A government's fiscal policy is the way the government spends and taxes to influence the performance of the economy.
When the government spends more than it receives, it runs a deficit. Governments finance deficits by borrowing money. Deficit spending—that is, spending funds obtained by borrowing instead of taxation—can be helpful for the economy. For example, when unemployment is high, the government can undertake projects that use workers who would otherwise be idle. The economy will then expand because more money is being pumped into it. However, deficit spending also can harm the economy. When unemployment is low, a deficit may result in rising prices, or inflation. The additional government spending creates more competition for scarce workers and resources and this inflates wages and prices.
The total of all federal government deficits forms the national debt. The size of the U.S. national debt has grown during the 20th century. The debt equaled about $25 billion in 1919 after World War I and about $260 billion in 1945 after World War II. In 1970 the debt stood at about $380 billion. Ten years later, the national debt had soared to nearly $1 trillion. In 2000 the national debt totaled $5.7 trillion.
Many people are concerned about the size of the U.S. national debt. They fear that a large amount of debt harms the economy and feel that the money used to pay interest on the debt could be better spent on other uses. Some people are also concerned about the ability of future generations to pay back the debt. However, many economists argue that the size of the debt is misleading. They point out that an important measure of the severity of a nation's debt is its size as a percentage of the nation's gross domestic product. Based on this measurement, the national debt of the United States during the mid-1990s was about half the size of the U.S. debt at the end of World War II in 1945. Other economists contend that when the balance of the debt is compared between years it does not account for the effects of inflation, which makes balances from later years appear larger.

Contributed By:Robert H. Haveman

Source : Microsoft ® Encarta ® 2006.