Ever heard the term “cyclical budget deficit” but weren’t sure what it meant, especially in the context of economic ups and downs? You’re not alone. Governments sometimes spend more than they collect in revenue, creating a deficit. But there are two main types: structural and cyclical. This article focuses on cyclical budget deficits, which occur naturally due to the ever-changing economic cycle. Understanding these fluctuations is crucial for anyone interested in economic trends, from students of economics to investors and the general public. By exploring the causes, impacts, and how they differ from structural deficits, you’ll gain valuable insights into government policy and the long-term health of the economy.
What is a Cyclical budget deficit?
A cyclical budget deficit occurs when government spending exceeds government revenue, and it occurs due to economic conditions. In other words, the deficit occurs due to the ongoing economic cycle. For example, it increases during a difficult economy, such as a recession. Instead, it goes down as the economy prospers. Thus, the deficit automatically increases or decreases during an economic expansion or recession.
A deficit occurs when government revenues are less than revenues. It comes from two factors: cyclical and structural. Long story short, the cyclical deficit plus the structural deficit equals the total budget deficit. Structural deficits are influenced by structural factors or deliberate government policies but are not affected by the business cycle.
Structural deficits persist over time unless the government deliberately reduces them, for example, with austerity measures. Since the government has to cover the deficit with debt, the increase in the structural deficit from year to year will lead to debt accumulation.
In contrast, a cyclical deficit results in rising and falling debt. Debt will fall when the economy prospers because the cyclical deficit is lower. Instead, it rises during a recession as the cyclical deficit increases.
Causes of cyclical budget deficits
A cyclical deficit is caused by economic conditions, namely the ongoing economic cycle. Cycles result in a decrease or increase in government revenue. In addition, it also affects several items in the government spending budget.
Sometimes, governments collect fewer taxes because the economy is bad, such as during a recession. However, some items tend to increase in the expenditure budget, so the cyclical deficit finally increases.
Then, after the economy comes out of recession, it becomes more prosperous. Economic activity increases, and business profits and household incomes improve. Consequently, the government can collect more tax revenue. On the other hand, some items in the spending budget are reduced, and finally, the cyclical deficit decreases.
How cyclical budget deficit work
Cyclical deficit changes occur because government revenues and expenditures change and depend on the current economic cycle. Some revenue and expenditure items change automatically. Some are cyclical, while others are counter-cyclical—we call them automatic stabilizers.
As we know, government revenue mostly comes from taxes, and it depends on economic conditions. Tax revenue follows the ongoing economic cycle. It rises during an economic expansion and falls during an economic recession.
During economic expansion, the economy prospers. Consequently, the government could collect more taxes. During this period, economic growth is high. Demand for goods and services increases. The unemployment rate is also low. As a result, the business faces solid profitability. Likewise, households see their income prospects as strong. Finally, the government can collect more taxes from the business and household sectors.
Conversely, economic conditions become difficult when the business cycle leads to a recession. As a result, the outlook for demand for goods and services is weak. Moreover, employment prospects are bleak due to high unemployment. This condition deteriorates business profitability and household income. As a result, government tax revenues declined during this period.
Meanwhile, several government spending items are also closely related to the ongoing cycle. Examples are welfare programs such as unemployment benefits and food stamps.
Now, take unemployment benefits as an example. The changes are counter-cyclical. It goes up and down following the cycle but works in reverse. During economic expansion, it decreases. The economy is prospering. And the unemployment rate is falling. As a result, spending on unemployment benefits also decreases.
In contrast, unemployment benefits increase during a recession. During this period, the economic outlook deteriorated, and the unemployment rate was high. As a result, the budget for unemployment benefits has also increased.
Changes in taxes and unemployment benefits above occur automatically. They rise and fall depending on the prevailing economic conditions without any deliberate action by the government.
Why Cyclical Budget Deficit Matters
Reviewing cyclical deficits is important for several reasons. The first is to examine the government’s fiscal policy stance: is the government deliberately increasing or decreasing the deficit to affect the economy? The second is the implications for government debt in the long term.
The budget deficit is broadly divided into two:
- Cyclical deficit
- Structural deficit
Changes in cyclical deficits occur because of economic cycles. Meanwhile, changes in the structural deficit occur due to changes in the government’s fiscal policy stance. Structural factors—such as an aging population—also influence structural deficits.
Cyclical deficits vs. Government policy stance
The government’s economic goals include high and sustainable growth. To achieve this goal, the government adopts fiscal policy to influence the economy through changes in its revenues and expenditures.
During a recession, the government adopts expansionary fiscal policies to stimulate economic activity. For example, assume that the previous year, the government ran a fiscal deficit. Then, to stimulate the economy, governments increase the deficit—for example, by lowering taxes and increasing spending—to increase aggregate demand and bring the economy out of recession.
On the other hand, during an economic boom, inflationary pressures are so high that they overheat the economy. To overcome this, the government implemented a contractionary fiscal policy by reducing the deficit, for example, by increasing taxes and reducing spending. Tax increases and spending cuts weaken aggregate demand and push the price level down.
Suppose we only focus on the total deficit without examining the underlying factors. In that case, we do not know whether the increase in the deficit is due to economic conditions or if there is a change in the government’s policy stance. As explained in the way cyclical deficits work above, they can change automatically without deliberate action by the government. For this reason, we must examine the cyclical items in the government budget. And by adjusting these cyclical items, we can conclude about the fiscal policy stance.
Effect on government debt
Debt resulting from a cyclical deficit is less dangerous than a structural deficit. It will go up and down with the deficit – and, therefore, follow the economic cycle as well. A recession will encourage government debt to tend to increase because the cyclical deficit is higher. Tax revenues are declining, but spending on programs like Medicaid, unemployment benefits, and food stamps is rising.
On the other hand, government debt due to a cyclical deficit will fall during expansion. This is because the government collects more taxes. Spending on these programs will automatically decrease, lowering the cyclical deficit, which in turn will lower debt.
Meanwhile, a structural deficit causes permanent debt unless the government deliberately changes its budget, for example, through austerity policies. The increase and decrease cannot change automatically following the business cycle. Rather, it persists over time as long as governments continue to spend more than they tax. And that’s dangerous for the economy in the long run. Accumulated debt leads to higher default risk and interest rates. Fiscal sustainability is also under threat as more government revenue is allocated to repaying debt rather than to productive spending.
