The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.
- The crowding out effect suggests rising public sector spending drives down private sector spending.
- There are three main reasons for the crowding out effect to take place: economics, social welfare, and infrastructure.
- Crowding in, on the other hand, suggests government borrowing can actually increase demand.
Types of Crowding Out Effects
Economies
Reductions in capital spending can partially offset benefits brought about through government borrowing, such as those of economic stimulus, though this is only likely when the economy is operating at capacity. In this respect, government stimulus is theoretically more effective when the economy is below capacity.
If this is the case, however, an economic downswing may occur, reducing revenues the government collects through taxes and spurring it to borrow even more money, which can theoretically lead to a vicious cycle of borrowing and crowding out.
Social Welfare
Crowding out may also take place because of social welfare, albeit 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.
Similarly, the creation or expansion of public health insurance programs such as Medicaid can prompt those covered by private insurance to switch to the public option. Left with fewer customers and a smaller risk pool, private health insurance companies may have to raise premiums, leading to further reductions in private coverage.
Infrastructure
Another form of crowding out can occur because of government-funded infrastructure development projects, which can discourage private enterprise from taking place in the same area of the market by making it undesirable or even unprofitable. This often occurs with bridges and other roads, as government-funded development deters companies from building toll roads or from engaging in other similar projects.