Why does the federal government spend more money than it takes in?
Government spending and taxing is called fiscal policy. Fiscal policy is a means by which government affects economic activity.
Here is how to think about the effect that deficit spending has on the economy.
Assume you and I are the economy. I spend all of my money on you and you spend all of your money on me. If we do this, we are both running balanced budgets. And note that my spending is your income, and your spending is my income.
Now assume I borrow money so I can increase my spending to buy more goods from you. If I do this, I run a deficit budget. But my “excess” spending or deficit must be equal to your additional income. This means you have a surplus budget.
My deficit = your surplus!
With that additional income you are likely to spend more, which would increase my income.
Economists know that when this occurs throughout our actual economy, deficit spenders create surplus incomes for others, who in turn spend more money. As spending rises in the real economy, more goods are produced and more people are employed.
Finally, think of the economy in terms of two sectors, the private sector and the public sector. When the private sector experiences recession or unemployment, the public sector deficit spends in order to create surplus budgets for households and firms.
What the private sector would not want is for the public sector to run surpluses because that would force the private sector into deficits.
In sum, deficit spending by some people raises other people’s incomes, and then these people encourage more economic activity by increasing their own spending. Fiscal policy is therefore a tool directed at reviving an economy from recession or stagnation. A great example is the government’s current deficit budget policy to mitigate the economic effects of COVID-19.
Now you know the essence of the economic role of government.