Cyclically Adjusted Budget Balance

Cyclically Adjusted Budget Balance Formula

What is the cyclically adjusted budget balance formula? This formula is the same as the budget balance formula; however, the way we view and interpret the formula will differ. The cyclically adjusted budget balance formula is the following:

\(\hbox{Savings}=\hbox{Tax Revenue}-\hbox{Government Spending}\)

What does the equation above tell us? The government's savings will be positive if tax revenues are greater than the amount it spends — a surplus. However, the government's savings will be negative if tax revenues are less than the amount it spends — a deficit. We can look at a quick example using the formula above to showcase this phenomenon.

How does this differ from the traditional budget balance formula? It differs based on how the government obtained its savings. For example, If the government obtained a deficit due to its fiscal policy, then it is a structural budget deficit. However, if the government obtained a deficit due to a downturn in the business cycle, then it is a cyclical deficit.

We want to distinguish between a government deficit/surplus based on the business cycle or fiscal action. Addressing any recessionary or inflationary period in the economy helps us understand if the government's fiscal policy is balanced, in a surplus, or in a deficit.

Cyclically Adjusted Budget Balance of the United States

Let's look at an example where the United States should use a cyclically adjusted budget balance. The 2020 Covid-19 pandemic affected every country in the world in many different ways — the economy was not left out of it either. The United States budget deficit in 2020 was $3.1 trillion.¹ Without taking into account any external factors, this is quite a large deficit. However, the importance of a cyclically adjusted budget balance is that we do look at external factors for clearer answers on government fiscal policy.

The United States experienced a recession in 2020 due to the pandemic.² The budget deficit for the United States is important in its own right, but the budget deficit alone does not tell us how much fiscal policy contributed to the deficit and how much the recession contributed to the deficit. The cyclically adjusted budget balance would correct and adjust for the recession in order to analyze the effects of the United States' fiscal policy on the deficit.

Cyclically Adjusted Budget Balance of the United States: Example

Let's look at a chart of the United States federal budget deficit unadjusted and adjusted for economic shocks.

Fig. 2 - United States Federal Budget Deficit (Adjusted and Unadjusted). Source: Congressional Budget Office³

What does the chart above tell us? The chart above shows the United States federal budget deficit from 2004-2007. It shows us the deficit for each year before it was cyclically adjusted and after it was cyclically adjusted. Recall that once the deficit is cyclically adjusted, what is "leftover" is the budget deficit that was caused by strictly fiscal policy. As we can see, there is not a massive difference between the budget deficit before and after adjusting. However, it's still important to see how much of the deficit was caused by fiscal policy and how much was caused by economic shocks.

Structural vs. Cyclically Adjusted Budget Balance

What is a structural vs. cyclically adjusted budget balance? We can view both definitions in terms of deficits for clarity.

A structural deficit is a deficit that occurs due to the government's fiscal policies.

For example, recall the budget balance formula:

\(\hbox{Savings}=\hbox{Tax Revenue}-\hbox{Government Spending}\)

If the government's spending is greater than the tax revenue it collects, then it will be in a structural deficit. Why will this occur? The government's fiscal policy may consist of lower tax rates for all income brackets and higher spending on government programs. The tax rate can be so low that the tax revenue never exceeds the amount the government is spending! This is a structural deficit since the government's fiscal policies are causing the deficit.

What about a cyclical deficit? A cyclical deficit will occur as a result of the economy. Rather than the deficit occurring because of fiscal policy (structural deficit), it occurs because of a recession in the economy.

Therefore, a cyclically adjusted budget balance can tell us what the structural budget balance is! Recall that a budget balance is comprised of fiscal policy and economic factors (recessions/booms). A cyclically adjusted budget balance shows us what the budget balance would be without any economic shocks/booms. A structural budget balance shows how only fiscal policy affected the budget balance. Therefore, a cyclically adjusted budget balance will reveal what the structural budget balance is.

Cyclically Adjusted Budget vs. Actual Budget

What is the difference between a cyclically adjusted budget vs. an actual budget? The actual budget is best expressed through the budget balance equation:

\(\hbox{Savings}=\hbox{Tax Revenue}-\hbox{Government Spending}\)

The actual budget merely looks at the tax revenue minus the government spending without distinguishing between a structural or cyclical deficit/surplus. Recall that a structural deficit is a deficit that occurs due to government spending, whereas a cyclical deficit is a deficit that occurs due to a recession in the economy. The actual budget combines both the structural and cyclical deficit/surplus to obtain total savings for the government.

Simply put, the actual budget is the budget balance without any corrections for structural and cyclical deficits/surpluses; the cyclically adjusted budget does make corrections to any deficit or surplus to account for the automatic changes in tax revenues whenever GDP changes.