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What’s it? A budget deficit means expenditures exceed income. While the term is commonly used to refer to government budgets, it also applies to individuals, households, non-profit entities, and public bodies. When an individual or household is in deficit, it means they overspend. For businesses, that means they are at a loss.
The government covers the deficit through debt, primarily through the issuance of debt securities. Likewise, when individuals spend more than their income, they have to borrow, for example, from banks. The continued deficit from year to year results in debt accumulation, which ultimately increases the default risk.
Budget deficit formula
A government deficit is when government spending exceeds revenue. We often refer to a government budget deficit as a fiscal deficit. Since the primary source of government revenue is from taxes, some might define a deficit as government spending that exceeds tax revenue.
Tax revenue flows to the government from the private sector, namely households and companies. It can be direct taxes such as income tax and indirect taxes such as value-added tax and excise.
The government’s money flows out in the form of expenditures on goods and services and transfer payments. Government spending includes routine expenditures (such as payment of employee salaries) and capital expenditures (such as infrastructure spending). Transfer payments consist of several programs, such as unemployment benefits and other social spending. Unlike government spending, transfer payments do not involve the exchange of goods and services.
In general, we can formulate the government budget as follows:
- Government budget = Revenue – Expenditure
Since the primary source of revenue comes from taxes, some literature might write the above equation as:
- Government budget = Net taxes – Government purchases
Both are the same. Net tax is the total tax revenue after deducting transfer payments. Meanwhile, government purchases consist of routine expenditures and capital expenditures.
When revenue equals expenditure, the government runs a balanced budget. But, when revenue is less than expenditure, then we say there is a budget deficit.
The opposite of a budget deficit is a budget surplus. When running a surplus, revenue exceeds expenditure. A budget surplus generates an excess of funds, representing one source of loanable funds in the economy. Specifically, a surplus means positive public savings. Meanwhile, a deficit means negative public saving (or public dissavings).
Structural deficit vs. cyclical deficit
Economists divide the budget deficit into two main categories:
- Cyclical deficit
- Structural deficit
Cyclical deficits occur due to the ups and downs of the business cycle. During a weak economy, tax revenues fall as the prospects for business profits and household income deteriorate. On the other hand, the budget for social spending, such as unemployment benefits, increases with the high unemployment level.
These conditions are the opposite during a prosperous economy. The government collects more taxes due to improved business profit and household income prospects. Also, social spending fell.
Meanwhile, structural deficits represent deficits that remain throughout the business cycle. In other words, it is unaffected by economic conditions. Structural deficits arise because of government discretionary decisions and are permanent.
Causes of the government budget deficit
The government budget is in deficit for several reasons. First, the government runs a deficit to stimulate short-term economic growth. As Keynesian economists suggest, a deficit is one way of stimulating aggregate demand and economic growth. We call this expansionary fiscal policy.
In this case, the government may move from a budget surplus to a budget deficit or increase the deficit from the previous period.
To carry out expansionary fiscal policy, the government can combine increased government spending and a decrease in taxes. For example, when lowering the income tax rate, individuals spend less to pay taxes. They have more money to spend on goods and services. As consumption increases, it stimulates demand and encourages businesses to increase production.
Second, budget deficits can occur when the economy is sluggish, such as during a recession. During this period, business profits and household income fell, reducing the amount of tax the government could collect.
On the other hand, the expenditure of some posts will usually increase. An example is social spending, such as unemployment benefits.
Furthermore, the budget deficit decreases when the economy is prosperous (economic expansion). Business profits and household income improve, and the government can collect more taxes. Also, spending, such as unemployment benefits, decreases due to lower unemployment rates.
Third, the government runs a deficit to support long-term programs to increase the economy’s productive capacity. The most common examples are infrastructure development, physical (such as roads and bridges), and non-physical (such as education and training). Infrastructure often requires significant funding, more than can be financed through taxes. Therefore, the government usually adopts a budget deficit and takes out loans to finance such programs.
Fourth, deficits also arise when unplanned events occur. For example, during the war, the government spends more on the defense budget. Likewise, during natural disasters, government spending tends to swell.
The effects of budget deficits
Budget deficits are a double-edged sword. While they can stimulate the economy in times of need, they also come with a price tag: national debt. This accumulated debt can have a ripple effect throughout the economy, potentially leading to higher interest rates, reduced investment, and even the risk of default. Let’s delve deeper into these potential consequences and explore the ongoing debate about the impact of budget deficits on economic growth.
Debt accumulation
The main consequence of the deficit is debt. The government must borrow money to finance the deficit, mainly through the issuance of debt securities.
Printing money is an alternative. However, it is an unwelcome option because it can lead to hyperinflation, causing the domestic currency’s purchasing power to fall. Hyperinflation endangers economic stability. So, the more sensible option is through debt.
If the deficit continues every year, the debt will increase. Therefore, we can say the current outstanding government debt is the accumulated deficit from previous years.
High interest rates
The increase in debt has two other effects, namely, higher interest expenses and difficulties in repaying. When implementing expansionary fiscal policy, the government increases the deficit and debt. In this case, the government increases its spending or cuts taxes.
This policy should increase aggregate demand, thereby stimulating an increase in economic activity and aggregate output. Businesses see the prospect of higher profits, encouraging them to increase production and recruit more workers. It creates more jobs and income for the household sector.
Higher economic growth allows the government to collect more taxes, which it can use to pay back debts. Therefore, in this case, the deficit and debt do not have an adverse effect.
However, persistent budget deficits and debt can have a negative effect. That increases the risk of default on government payments. Investors anticipate this increased risk by asking for a higher premium. As a result, the economy’s interest rates tend to be high when debt continues to accumulate over time.
Crowding out effect
The next consequence is the crowding-out effect. An increase in debt raises interest rates and reduces private-sector investment.
To discuss it, let us recall the concept of national savings. Economists define national savings in the following formula:
- National savings = Public savings + Private savings
National savings represent a source of loanable funds in the domestic economy. When running a budget deficit, public saving is negative. As a result, national savings decrease, as does the supply of loanable funds. As the supply of loanable funds decreases, liquidity in the economy tightens, ultimately leading to an increase in interest rates.
Higher interest rates make business investment more expensive. Businesses are reluctant to bear the higher cost of funds, forcing them to delay investment and expansion. Likewise, households put off bank loans to finance purchases of goods such as houses and cars: long story short, consumption, and investment decrease.
The impact of reduced consumption and investment on aggregate demand is likely to be greater than what the budget deficit could drive. Thus, instead of stimulating economic growth, deficits have the opposite effect.
The budget deficit debate
When it comes to government spending exceeding revenue, economists have different viewpoints on its impact and the best course of action. Let’s explore the key arguments in this ongoing debate:
Keynesians in the corner of stimulus: Keynesian economists believe deficits can be a useful tool during economic downturns. They argue that by increasing government spending on infrastructure, social programs, or even cutting taxes, the government injects more money into the economy. This increased aggregate demand stimulates businesses to produce more, which in turn leads to job creation and economic growth. In essence, deficits can act as a temporary shot of adrenaline during a recession.
Classical and monetarist concerns: On the other side of the spectrum, classical and monetarist economists are more cautious about deficits. They worry that excessive government borrowing can lead to inflation, a situation where prices rise rapidly.
Additionally, they raise the concern of “crowding out.” When the government borrows heavily, it competes with businesses for loanable funds in the economy. This competition can drive up interest rates, making it more expensive for businesses to borrow money and invest. As a result, investment and economic growth might suffer.
The Balanced budget vs. Cyclical management: Some economists advocate for a more balanced approach. They believe governments should strive for balanced budgets over the long term, but also acknowledge the need for flexibility.
During periods of economic expansion, surpluses might be ideal, allowing the government to pay down debt and build a buffer for future downturns. Conversely, during recessions, temporary deficits might be necessary to stimulate the economy. This cyclical management approach aims to strike a balance between fiscal responsibility and economic growth.
The budget deficit debate highlights the complexity of economic policy. There’s no one-size-fits-all answer, and the best approach likely depends on the specific economic circumstances. By understanding the different perspectives, we can engage in a more informed discussion about managing government finances.
