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What’s it: A budget surplus is when the government plans to spend less than it earns. In other words, the government’s budgeted revenue is greater than the government’s spending. Surpluses may be an option when the economy is prospering, where tax revenues are rising, and some expenditure items are declining. And the government can use the surplus to pay off debt, reducing the burden on future budgets.
How does a budget surplus occur?
A budget surplus arises because the government’s revenues exceed its expenditures. It is likely to happen if:
Government revenues increased more than budgeted expenditures: Imagine a strong economy with businesses making more profits and households earning higher incomes. This translates to higher tax collections for the government (e.g., income tax and sales tax). If these revenue increases are greater than what the government had planned to spend, a surplus emerges.
Government revenues are unchanged compared to before, but the government is spending less: This scenario could occur if the government maintains its tax collection levels but actively cuts spending in certain areas. Maybe it streamlines programs, renegotiates contracts with vendors, or finds efficiencies in operations. Here, even if tax revenue doesn’t rise, a surplus appears because spending falls below the initial budget.
Government revenues fell but were less significant than the decline in budgeted spending: This situation might happen during a mild economic slowdown. Tax revenue might dip slightly as businesses and households earn a little less. However, if the government anticipated this slowdown and proactively reduced its spending plans by a larger amount, the decline in revenue wouldn’t be enough to erase the surplus. The controlled spending acts as a buffer against a minor economic downturn.
When does the government run a budget surplus?
Under a budget surplus, government revenues exceed spending. It usually happens when the economy is prospering where the economy is expanding. During this period, economic activity increased. Corporate profits increased as demand for goods and services strengthened. In addition, households have more income, and their job prospects improve. Consequently, the government can collect more taxes.
On the other hand, the government budgeted less spending. Some programs, such as welfare benefits and unemployment compensation, are declining. This is because households are more prosperous, and the unemployment rate is falling. Therefore, the expenditure for the program is also lower.
The opposite occurs during a recession. The economy is tough. Households face deteriorating income and employment prospects. On the other hand, businesses face profit pressures due to weak demand. They then take efficiency measures such as reducing the labor. As a result, government revenues tend to fall. However, government spending on welfare and social benefits is increasing. In this situation, the government may run a budget deficit.
Apart from cyclical factors, the deficit may also be an option due to government discretion. It is difficult to rely on the private sector during a recession to increase demand. Households save more and spend less on goods and services. On the other hand, businesses are cutting back on investment due to weak demand. As a result, the economy relies on the government to stimulate growth.
The benefits of a budget surplus
Running a budget surplus has implications for several aspects of the economy. It contributes to an increase in national savings to finance capital investment, which increases the economy’s productive capacity. In addition, the surplus contributes to a reduction in debt, which is positive for interest rates in the economy.
However, the implications for the economy can vary depending on the reason behind the surplus, whether it is due to a decrease in spending or an increase in income.
Lower debt
A budget surplus indicates a healthy budget. The government has excess money because it earns more than it spends. Because it has extra funds, the government does not have to take on debt. Instead, it can allocate them to pay off debt, lowering future principal and interest expenses. As a result, the debt-to-GDP ratio—and therefore the risk of default—is decreasing.
With lower debt, government fiscal is more sustainable. The government can use future revenues to finance productive programs to increase the tax revenue base in the long term.
Lower interest rates
A decrease in debt contributes to a decrease in interest rates in the economy. Because the risk of default is lower, investors may be willing to accept lower interest rates. Finally, coupons and government bond yields fall.
The private sector likes a low-interest environment because they can add new loans at a low cost. As a result, consumers increase borrowing to finance consumption. Likewise, businesses get a lower cost of funds to finance investments. For example, businesses can issue bonds by paying lower coupons as government bond yields decline.
Meanwhile, the deficit produces the opposite effect. The deficit puts upward pressure on interest rates in the economy, piling up government debt. The principal and interest expenses accumulate, increasing the default risk and prompting investors to demand higher interest to compensate for the higher risk.
Investment increase
A budget surplus means positive public savings. Coupled with private savings, it forms national savings, representing the total loanable funds provided by the domestic economy. National savings are useful for financing domestic investment and lending to foreigners.
The government can use the surplus to fund several productive programs. For example, it can finance infrastructure development, both physical and non-physical. Such investments increase the capital stock in the economy, which is beneficial for long-term economic growth.
In addition, infrastructure investment contributes to creating a multiplier effect. More jobs and income are created for households and businesses, encouraging more consumption and investment in the economy.
Then, the government can allocate its surplus to increase public investment in education and health. This will improve human capital quality, which is key to long-term economic growth.
Future tax reduction
In addition to financing productive programs, the government may cut future taxes and cover tax cuts with the available surplus. Lower taxes increase disposable income and increase business profits. Finally, household consumption and business investment increase because they have to pay fewer taxes, providing great benefits for future economic growth.
Unfortunately, tax cuts are often a political rather than an economic choice. The incumbent may vote for that option before elections to increase his popularity.
Deflationary effect
As I explained, a surplus can occur because government spending decreases or tax revenue increases. Both weaken aggregate demand, creating deflationary pressures in the economy. The price level tends to be pushed down, which can lead to deflation, which is a negative inflation rate.
Reduced government spending means less money is being spent on the wider economy. That causes aggregate demand to decline.
Likewise, when a surplus results from higher taxes, businesses, and consumers have fewer dollars to spend and invest. Instead, they have to spend more dollars to pay taxes. Again, this situation reduces aggregate demand and creates deflationary pressures in the economy. Finally, a decline in aggregate demand could weaken economic growth and create a deflationary effect.
Fiscal flexibility
Surplus increases budget flexibility. Using the surplus to pay off debt reduces the budget burden, giving the government greater budget flexibility.
Budget flexibility makes it easier for the government to set future budgets. For example, the government may choose to increase spending or reduce taxes in the future to stimulate the wider economy using the currently available surplus.
Such flexibility is non-existent when government debt remains large. Governments have to pay debts regardless of whether the economy is prospering or is down. Thus, accumulated debt makes it difficult to increase spending or lower taxes in the future.
The drawbacks of a budget surplus
While budget surpluses offer numerous advantages, there are also potential drawbacks to consider. Here’s a closer look at some of the possible downsides:
Deflationary pressures
Large surpluses can sometimes create deflationary pressures in the economy. This happens when excessive spending cuts or tax hikes lead to a decrease in aggregate demand, the total amount of goods and services people are willing and able to buy.
Imagine a scenario where the government cuts spending significantly to achieve a surplus. This injects less money into the economy. With less money circulating, consumers have less to spend, and businesses experience lower demand for their products. This can lead to falling prices – a hallmark of deflation.
Reduced economic growth
Deflationary pressures, coupled with lower government spending, can dampen economic activity in the short term. Businesses may be hesitant to invest if they see prices falling, potentially leading to slower economic growth. Additionally, reduced government spending on infrastructure projects or social programs can also stifle economic activity in the short run.
Political motivations
Sometimes, tax cuts funded by surpluses may be driven more by political agendas than long-term economic needs. Politicians might use surpluses as an opportunity to enact tax cuts before elections to boost their popularity. While tax cuts can be beneficial, if not carefully planned, they can lead to a decrease in government revenue in the long run. This could make it difficult to maintain essential services or respond to future economic challenges.
In conclusion, budget surpluses, while generally positive, require careful management to avoid unintended consequences. Policymakers must strike a balance between achieving long-term fiscal health and supporting short-term economic growth.
