What is the crowding effect?

The "crowding effect" or "crowding out effect" refers to the phenomenon where increased government spending leads to reduced spending in the private sector. This concept is typically discussed in the context of expectations about future economic conditions and government policies.

In the clip from the EconTalk episode "John Taylor on the State of the Economy", John Taylor and Russ Roberts discuss the crowding out effect in terms of future tax expectations. They explore the idea that if people anticipate higher taxes due to increased government spending, they might choose to spend less today. While there's evidence for behavior change at a microeconomic level, such as specific incentive programs showing clear responses, the macroeconomic evidence connecting people's expectations of higher future taxes (due to government spending) to their current spending habits is less robust. The difficulty in measuring expectations makes it challenging to have strong empirical evidence for this broader economic behavior 1.