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Structural budget deficits are a hot topic in economics, often mentioned in news headlines but rarely explained clearly. Simply put, it occurs when a government spends more than it collects in revenue, and this gap persists even during economic prosperity. This pattern, unlike temporary deficits tied to economic downturns, raises concerns about a government’s long-term fiscal health and its potential impact on the economy as a whole. This article will break down the concept, explore its implications, and answer the question: Do structural deficits pose a real threat to your wallet?
Understanding structural budget deficit
What’s it: A structural budget deficit is when government spending exceeds government revenue, and it persists throughout the business cycle. In other words, the deficit is unrelated to the current business cycle. So, it may persist even as the economy expands and operates at full employment.
Economists look to changes in the structural deficit to indicate the government’s fiscal stance. If the structural deficit increases, it indicates the government is deliberately pursuing an expansionary fiscal policy to stimulate economic growth. On the other hand, if the structural deficit declines, the government may try to curb inflation or adopt contractionary fiscal policies.
The structural deficit plus the cyclical deficit represents the total budget deficit. So, there are times, such as during a recession, when the government’s budget deficit increases not due to an increase in the structural deficit but from a cyclical increase in the deficit.
Because it is unaffected by the business cycle, the fiscal deficit is a major factor in government debt in the long term. As it increases over time, the debt becomes increasingly piled up. And the situation could lead to higher fiscal risk, increased default rates, and lower sovereign ratings.
Why is the structural budget deficit important?
Examining the structural budget deficit is important to reveal the government’s fiscal policy stance. The change in the deficit reflects a deliberate change by the government to affect the economy.
For example, during a difficult economy, such as a recession, the government usually increases the deficit to stimulate economic growth. However, if we focus solely on increasing the government’s deficit and conclude the government is pursuing an expansionary fiscal policy, our conclusions can be misleading. Why?
An increase in the deficit can occur for two reasons:
- Economic conditions
- Deliberate intention by the government
As we learned in macroeconomics, some items in the government budget are counter-cyclical. We call them automatic stabilizers. Two examples are taxes and unemployment benefits.
During a recession, tax revenues tend to decline as the prospects for business profits and household incomes deteriorate. On the other hand, unemployment benefits increase due to an increase in the unemployment rate. Thus, the government’s budget deficit in this period tends to increase as government revenue decreases while expenditure increases. This is the reason why economic conditions can lead to an increase in the deficit even when the government does not change its fiscal policy stance.
Meanwhile, an increase in the deficit can also occur because the government is deliberately doing it to get the economy out of recession. In this case, the government took an expansionary fiscal policy stance.
We can examine the structural budget deficit to distinguish whether the increase in the deficit is due to economic conditions or changes in the government’s policy stance. In the case above, if the increase in the total deficit is greater than the difference between the tax reduction and unemployment benefits, the government is likely to adopt an expansionary policy stance. Long story short, the structural deficit increased, although, at the same time, the cyclical deficit also increased.
Then another reason why structural deficits are important is that they affect government debt in the long run. Debt accumulates when the structural deficit continues to increase from year to year. This situation can jeopardize fiscal sustainability and raise problems such as:
- Higher default risk
- Sovereign rating downgrade
- High-interest rates in the economy
Cyclical vs. Structural budget deficits
The budget deficit is broadly divided into two categories:
- Structural deficit
- Cyclical deficit
Structural deficits are unrelated to economic conditions. It can persist even as the economy expands or is at full employment. So, the economic cycle does not affect it. However, the deficit could occur due to changes in the government’s policy stance.
In addition, the structural deficit can also be influenced by long-term structural factors such as an aging population. As the aging population is less productive, it causes a decrease in output and income in the economy. It lowers the income tax paid on labor income. But, on the other hand, it also results in more retirees, leading to a bigger spending budget for them.
On the other hand, cyclical deficits are closely related to the current business cycle. Therefore, it changes according to the current cycle. For example, when it is expanding, it tends to decrease because the government can collect more taxes, and some outlay – such as unemployment benefits – decreases.
Conversely, during a recession, the cyclical deficit will increase. On the one hand, the government collects fewer taxes as private sector profits and income prospects decline. On the other hand, it should spend more on welfare programs such as unemployment benefits.
How does a structural budget deficit work?
Take a simple example. Government revenue has been unchanged for two years and remains at $1,000 in 2020 and 2021. Meanwhile, government spending increased from $1,200 in 2020 to $1,400 in 2021.
This data shows that the government deficit in 2020 is $200 ($1,000 – $1,200). Meanwhile, in 2021, it increases to $400 ($1,000 – $1,400). Is the increase in the deficit due to the government’s intention or due to economic conditions?
From this simple example, we know that government revenues are unchanged. Thus, taxes are likely not an option as an expansionary fiscal policy tool to stimulate economic growth. If the government uses taxes, they should decrease. Lower taxes stimulate more consumption and investment, increase aggregate demand, and stimulate production. But, we can see that the tax in 2021 remains the same as the previous year.
Next, we examine the items in spending to see if the increase in the deficit is due to structural or cyclical factors. Say, spending increases because welfare benefits go up, which increases by $200.
From this information, we can conclude that the increase in the deficit occurred due to cyclical factors, not changes in the government’s fiscal policy stance. In a sense, the government does not intentionally increase the government deficit to stimulate economic growth. Instead, the deficit occurred because the economic situation was deteriorating, resulting in welfare benefits automatically increasing.
Why are structural deficits more concerning?
A budget deficit arises when the government’s revenues are less than its expenditures. As a result, the government must borrow to cover the shortfall, generally by issuing debt securities.
The government’s structural deficit is more worrying than the cyclical deficit because it affects long-term fiscal sustainability. Unlike cyclical deficits, structural deficits will persist over time.
The cyclical deficit rises and falls following the economic cycle. Thus, government debt rises as long as the economy deteriorates due to higher cyclical deficits. But, once the economy recovers and is on its way to prosperity, it will decrease automatically due to a lower deficit.
Conversely, when the structural deficit continues to increase, the government must continue to owe a debt, causing debt to accumulate. Consequently, the ability to repay the debt will further decline, threatening fiscal sustainability.
If the situation is not addressed by increasing government revenues or lowering spending further, it could hurt the economy. The debt-to-GDP ratio rose. And if the ratio is too high, the default risk increases.
A higher default risk lowers the sovereign rating. Investors are more doubtful about the government’s ability to pay off its debt obligations. Finally, they ask for higher interest to compensate for the higher risk. As a result, interest rates in the economy will be high.
High interest rates impact economic activity. For example, borrowing costs become expensive for consumers, prompting them to reduce consumption. Businesses also reduce investment because they have to raise funds at a higher cost.
To deal with accumulated debt, the government may take austerity measures. The policy aims to reduce the deficit (and thus debt) and avoid a debt crisis. But, it could hurt the economy in the short term. Austerity measures involve increasing taxes, cutting budgets, or choosing to combine the two.
The austerity policy is certainly not popular with businesses and households. They have to bear a higher tax burden or face essential budget cuts, such as unemployment benefits and health care.
