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What’s it: A balanced budget is when a government’s spending equals its revenue. Therefore, there is no surplus or deficit. So, the government does not need to borrow to cover its expenses. So, there is no government increase. However, achieving it consistently from year to year is difficult due to a volatile economy, affecting government spending and revenues.
Why should government fiscal lead to a balanced budget?
Some economists believe a balanced budget should be achieved by averaging over the business cycle. For example, in certain years, the government runs a budget deficit, but in other years, it runs a budget surplus. So, if we average, it leads to a balanced budget.
What are the reasons for the argument? On the one hand, tax revenues tend to increase as economic and business activity grows during expansion. And the government could collect more taxes as household incomes and business profits improve.
On the other hand, government expenditure tends to fall because the government spends less on certain items. For example, the government spends less on unemployment benefits because unemployment declines during this period. Likewise, other welfare programs will decline because the taxpayers are more prosperous during this period.
In addition, reducing spending is important to prevent the economy from overheating. During the expansion, the economy prospered. Aggregate demand is increasing due to strong household consumption and business investment, and the price level is creeping up. If the government increases its spending, it will increase aggregate demand further, generating stronger upward pressure on inflation. Inflation rising too sharply is not healthy for the economy because the purchasing power of money evaporates quickly.
For this reason, the budget tends to be in surplus during expansion. As a result, tax revenue increased on the one hand. And on the other hand, government spending decreased.
Meanwhile, during a recession, the government runs a budget deficit. Apart from being the government’s discretionary policy to stimulate economic activity, the deficit also occurs due to cyclical factors. During this period, tax revenues declined as the outlook for household income and business profits deteriorated. Thus, the government collects fewer taxes.
In addition, spending on welfare and social programs increased due to deteriorating economic conditions. For example, the government spends more on unemployment benefits because of the high unemployment rate.
How do economists view a balanced budget?
Classical economists argue that a balanced budget should be the goal of government policy. Thus, the government does not need to borrow and increase debt.
Debt could weigh on fiscal sustainability as the government has to pay principal and interest, which may be difficult during a sluggish economy such as a recession.
When the government runs a persistent budget deficit, the debt burden builds up, increasing the risk of default. In addition, the accumulated debt contributes to high interest rates in the economy. And high-interest rates discourage private investment because they have to bear high financing costs.
In addition, taking austerity steps to pay off debt can be painful for the economy. The government must increase taxes, reduce spending or choose to combine the two options. Both options hurt aggregate demand and short-term economic growth. Citizens have to face increased taxes and, at the same time, face declining public services due to reduced budgets.
Meanwhile, Keynesian economists argue that running a deficit is an important option to stimulate the economy. Therefore, the government needs to adopt it to get the economy out of recession.
During a recession, it is difficult to encourage households to increase consumption and businesses to increase investment. Instead, they tend to take efficiency measures. Households are reluctant to spend more because their job and income prospects deteriorate. Businesses saw weak household demand, forcing them to cut production and pursue efficiency. As a result, the economy depends on the government to get out of recession. For this reason, running a budget deficit is an option.
Meanwhile, the government can run a surplus when the economy is expanding. This is because the government spends less than it earns. In this way, the government can strike a balance in the long run.
The balanced budget multiplier
The balanced budget multiplier refers to the change in aggregate output when the government changes its spending and taxes at the same rate. Here, balance does not have to be when the government runs a balanced budget, or revenue equals its expenditure. Instead, the government changes its revenues and expenditures at an equal rate. So, if previously the government ran a budget surplus or deficit, it would not change from before.
Suppose the government ran a surplus in its previous budget of $100, coming from $700 of tax revenue minus $600 of spending. However, because the economy is sluggish, the government increases taxes and spending by $200. Thus, government revenues are $900, and expenditures are $800, keeping the surplus at $100.
So how do these budget changes create a multiplier effect on the economy? The multiplier effect occurs because the decrease in aggregate demand due to an increase in taxes is lower than the increase in aggregate demand due to an increase in government spending.
When the government increases spending by $100, it increases aggregate demand by $100. Recall the aggregate demand formula to answer that.
- Aggregate demand = Household consumption + Business investment + Government spending + Net exports
On the other hand, an increase in tax of $100 will cause a decrease in aggregate demand by less than $100. This is because the increase only lowered private disposable income by $100. However, the effect on consumption and investment could be smaller depending on how sensitive the household and business sectors are.
To simplify the illustration, let’s say a tax increase is passed on to the household sector. Let’s recall the marginal propensity to consume (MPC). Economists define it as:
- MPC = ∆Consumption / ∆Disposable income = ∆Consumption / ∆(Income – Tax)
or
- ∆Consumption = MPC x ∆Disposable income = MPC x ∆(Income – Tax)
Assume that the household sector’s MPC is 0.8. It shows that household consumption will fall by $0.8 when income decreases by $1. The remainder, $0.2, represents a decrease in savings. In other words, households will reduce consumption by $0.8 and save by $0.2 when their income falls by $1.
Back to the case above. As taxes increase by $100, disposable income will decrease by $100. Since not all income is allocated for spending – but also for saving – the tax increase reduces household consumption by:
- ∆Consumption = 0.8 x (-$100) = -80.
On net, aggregate demand will increase by $20 when the government increases its household taxes and spending by $100.
