How Government Finances Its Spending

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Traditionally there are three main ways through which the government raises money: taxation, budget deficits, inflation.

Taxation is when the government decrees that individuals and corporations must pay money to the government according to certain rules.

Budget deficit happens when the government borrows money from individuals, corporations or other governmental institutions, by selling bonds. It is then legally obligated to pay back these loans with interest.

When the government raises funds through inflation, it creates new money (“out of thin air”) and uses it to finance its purchases.

Let’s see how this this distorts the economy even more. (view previous lesson for more)

Imagine an extreme case where the government imposes a 200% income tax, meaning that for every dollar you earn, you are legally required to send the IRS a check for $2. In this scenario it is clear that very few people would work, or at least very few people would work and report their incomes to the government at tax time. The government would collect very little revenue, and wouldn’t be able to spend much money pulling resources away from their most profitable uses. Everyone would have to quit his or her official job and would be forced to live off the land, or work in black market jobs that could be hidden from the authorities. The economy would be plunged into extreme privation because of the punitive tax code, even though it raised very little revenue and the government didn’t have a large budget.

Now we see that governments distort economies both when they spend and collect funds.