Budget Deficit

Budget Deficit Causes

Understanding the causes of a budget deficit is essential for addressing and mitigating its impact on the economy. Here are some common budget deficit causes:

Economic downturns and rising unemployment

Recessions and rising unemployment can lead to lower tax revenues and increased welfare spending. For example, during the 2008 financial crisis, many governments experienced decreased tax revenues as businesses struggled and unemployment rose, contributing to budget deficits.

Decreased consumer spending

A decrease in consumer spending results in less tax revenue for the government. During periods of economic uncertainty, consumers may cut back on their spending, leading to reduced sales tax revenue and exacerbating budget deficits.

Increased government spending and fiscal stimulus

Governments may increase spending on public services, infrastructure, or defense to stimulate economic growth or address pressing needs. Additionally, using fiscal stimulus to lift aggregate demand can contribute to budget deficits. During the COVID-19 pandemic, governments worldwide increased spending on healthcare, relief packages, and economic stimulus plans, leading to larger budget deficits.

High interest payments

Governments may have to make large interest payments on their existing debts, reducing the available funds for other expenses. An increase in interest rates can cause a rise in debt service costs, exacerbating budget deficits. Countries with high levels of public debt often allocate a significant portion of their budgets to service this debt.

Demographic factors

An ageing population or other demographic changes can lead to increased social services and healthcare spending, contributing to budget deficits. For example, many developed countries face the challenges of an ageing population, putting pressure on their pension systems and healthcare services.

Unplanned Emergencies

Natural disasters, public health crises, or military conflicts can strain a government's budget, leading to deficits. For instance, when Hurricane Katrina hit the United States in 2005, the government had to allocate significant funds for emergency response and recovery efforts, contributing to a budget deficit.

In summary, budget deficit causes can include economic downturns and rising unemployment, decreased consumer spending, increased government spending and fiscal stimulus, high interest payments and rising interest rates, demographic factors, and unplanned emergencies. Recognizing and addressing these factors can help governments manage their budgets more effectively and maintain fiscal stability.

Budget Deficit Formula

Did you know there is a formula to calculate the budget deficit? If not, then today is your lucky day! Let's take a look at the budget deficit formula:

\(\hbox{Deficit}=\hbox{Government Spending}-\hbox{Tax Revenues}\)

What does the formula above tell us? The greater the government spending and the lower the tax revenues, the greater the deficit. In contrast, the lower the government spending and the greater the tax revenues, the lower the deficit will be — potentially even a surplus! Let's now take a look at an example that utilizes the formula above.

Budget Deficit vs Fiscal Deficit

What is the difference between a budget deficit vs a fiscal deficit? It is a rather small distinction, but a distinction nonetheless. Recall that a budget deficit occurs when the government's tax revenue is lower than its spending. A fiscal deficit is merely a type of budget deficit. A fiscal deficit's main difference from a budget deficit is that every country has a different fiscal year. For example, the United States' fiscal year is from October 1 to September 30, whereas Canada's fiscal year is from April 1 to March 31. Depending on how each country classifies a fiscal year will determine its fiscal deficit or surplus.

Cyclical Budget Deficit

A cyclical budget deficit occurs when a government's spending exceeds its revenue due to temporary economic fluctuations, such as a recession. In simpler terms, it's a financial imbalance that arises during economic downturns and typically resolves when the economy recovers.

Take a look at the example to better understand this concept:

Structural Budget Deficit

A structural budget deficit occurs when a government consistently spends more than it collects in revenue, regardless of whether the economy is in a period of growth or decline. In simpler terms, it's like a constant financial imbalance that remains even when the economy is booming and employment rates are high.

Below is another example that will help you grasp the concept of structural budget deficit and it's difference from cyclical budget deficit.

Budget Deficit Economics

Let's discuss the budget deficit in economics. A budget deficit can impact the economy, both good and bad. Let's look at a few of them.

Crowding Out

Crowding out can occur with a budget deficit. In order for the government to increase government spending, the government will have to borrow money from the loanable funds market to finance its spending. However, the loanable funds market is the same market that private businesses also use for their investments. Essentially, private businesses are competing with the government for loans in the same market. Who do you think is going to win that battle? The government will end up with a majority of the loans, leaving little for private businesses. This will cause the interest rate to increase for the few loans available. This phenomenon is known as crowding out.

You may be thinking, isn't a major point of expansionary fiscal policy to increase investment? You would be correct; however, crowding out can be an unintended consequence of deficit spending. Therefore, it's important for the government to recognize this potential problem when increasing government spending during recessions.

Defaulting on Debt

Defaulting on debt can also occur with budget deficits. If the government runs prolonged and large deficits year after year, it can catch up to them and cause catastrophic issues for the economy. For example, if the United States continually runs budget deficits, it can finance it in one of two ways: increase taxes or continue to borrow money. Increasing taxes is very unpopular and could deter the government from taking this route. This leads to the other option of borrowing money.

If the United States continues borrowing without paying its debts, the United States can eventually default on its debt. Think about yourself, if you continue to borrow instead of paying off your debts, what would happen to you? The same principle applies to governments, and it can produce bad outcomes!

Advantages and Disadvantages of Budget Deficit

Budget deficits can have both positive and negative implications for a country's economy. While they may contribute to economic growth and development, they can also lead to financial instability and other economic challenges. In this context, it's essential to evaluate the advantages and disadvantages of budget deficits to make informed fiscal decisions.

Advantages of Budget Deficits

A budget deficit can sometimes serve as a powerful tool for promoting economic growth and addressing pressing social needs. Here are some advantages of budget deficits:

Economic Stimulus

Deficit spending can help stimulate economic growth during a recession by increasing aggregate demand, creating jobs, and boosting consumer spending.

Investment in Infrastructure

Budget deficits can finance essential investments in infrastructure, education, and healthcare, which can lead to long-term economic growth and improved quality of life.

Countercyclical Fiscal Policy

Deficit spending can help stabilize the economy during economic downturns by acting as a countercyclical fiscal policy, reducing the severity and duration of recessions.

Disadvantages of Budget Deficits

On the other hand, budget deficits can also have negative consequences on the economy and financial stability. Here are some disadvantages of budget deficits:

Increased Public Debt

Persistent budget deficits can lead to a rise in public debt, which can burden future generations with higher taxes and reduced public services.

Higher Interest Rates

Increased government borrowing can result in higher interest rates, making it more expensive for businesses and consumers to borrow money, potentially slowing down economic growth.

Inflation

Financing budget deficits by printing more money can lead to inflation, eroding the purchasing power of consumers and negatively affecting the overall economy.

In summary, budget deficits offer advantages such as economic stimulus, investment in infrastructure, and countercyclical fiscal policy, while also presenting disadvantages like increased public debt, higher interest rates, and inflation. By carefully considering these factors, policymakers can strike the right balance between the benefits and drawbacks of budget deficits to achieve sustainable economic growth and fiscal stability.

How to Reduce a Budget Deficit?

Let's examine some ways the government can reduce a budget deficit.

Increasing Taxes

Tax increases can help reduce a budget deficit. To see why this is, recall the formula for calculating a budget deficit.

\(\hbox{Budget Deficit}=\hbox{Government Spending}-\hbox{Tax Revenues}\)

Budget deficits occur when there is high government spending and low tax revenues. By increasing taxes, the government will be receiving more tax revenues which can offset the high government spending. The downside to this is the unpopularity of high taxes. Most people will have a negative reaction to the government increasing taxes, even if it is for lowering the deficit. Regardless, it is still effective at doing so. Using the same formula, let's go over an example of tax increases lowering the budget deficit.

Now let's take a look at the other way to reduce the budget deficit.

Decreasing Government Spending

Decreasing government spending can also help in reducing the budget deficit. To see why this is, we will look at the budget deficit formula once more:

\(\hbox{Budget Deficit}=\hbox{Government Spending}-\hbox{Tax Revenues}\)

If the government does not want to increase taxes due to public disapproval, the government can instead reduce government spending to reduce the budget deficit. This can also be unpopular with this public, since decreasing government spending could decrease spending on popular programs that people enjoy, such as Medicare. However, decreasing government spending can potentially be more favorable than tax increases.

Fig. 1 - U.S. Budget Deficit and Recessions. Source: Congressional Budget Office¹

The graph above shows the U.S. budget deficit and recessions from 1980–2020. As you can see, the United States has seldom been in a budget surplus in the past 40 years! Only in 2000 did we see a minor budget surplus. Additionally, the budget deficits seem to increase the most when recessions are present — most notably in 2009 and 2020.