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A government affects the economy in many ways, including through fiscal policy, the way the government taxes its population and spends its resources, and through monetary policy and regulation, which is covered later. All governments require money to operate, so they raise money through taxation. Often governments augment the income generated through taxation by borrowing money. Most governments tax and spend using myriad methods, including spending, borrowing, and running deficits, all of which strongly affect the economy.

 
THREE STRATEGIES USED BY GOVERNMENTS TO IMPROVE THE ECONOMY

Fiscal Policy

Monetary Policy

Regulation

Governments create tax policies and budgets that allow them to allocate resources the most efficiently.Governments control the amount of money circulating in the economy to control inflation, borrowing, and spending in order to stabilize the economy.Governments establish economic rules to protect consumers, balance labor and capital, and foster an atmosphere of fair trade.

Taxes

Taxes are seldom neutral. Most tax systems produce winners and losers because governments frequently use their tax policies to encourage—or discourage—certain types of behavior. If a government wants to reward investment, for example, it might cut taxes on capital gains (income earned from selling investments). Alternatively, if a government wishes to discourage drinking alcohol, it might tax liquor at a high rate.

In addition to various taxes on goods and services, most governments rely on one, some, or all of three types of income taxes: progressive, regressive, and flat. Progressive and regressive taxes directly affect income distribution. Regardless of which tax system is used, governments shape people’s behavior through the taxes they levy on citizens.

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