The Government Budget

Government Budget Deficit

Let's go into more depth on a government budget deficit. To do so, we need to take a deeper look at the budget balance equation.

Government Budget Deficit: Equation and Example

Let's look at the budget balance equation once more:

$$\begin{gathered} S_{Government}=T-G-TR \\ Where: \\ S:\hspace{0.17em}Savings \\ T:\hspace{0.17em}TaxRevenue \\ G:\hspace{0.17em}GovernmentSpending \\ TR:\hspace{0.17em}GovernmentTransfers \end{gathered}$$

What does the budget balance equation above tell us? A federal budget deficit will occur if tax revenue is less than the combined total of government spending and transfers — this will result in a negative budget balance. Let's look at a brief example below where we need to determine whether the budget is in a surplus or a deficit:

Government Budget Deficit: Causes

Depending on the fiscal policy, a government may be more likely to be in a federal budget deficit for the fiscal year. Expansionary Fiscal Policy tends to increase federal budget deficits and decrease federal budget surpluses due to its high spending and low taxes.

Government spending also means government borrowing — governments do not just have billions of dollars lying around! Borrowing billions of dollars seems like a scenario that the government wants to avoid. Why might the government put itself in a federal budget deficit?

The government may deficit spend during a recession. A recession prompts expansionary fiscal policy to close the negative output gap. The government may choose for the spending to increase and taxes to decrease — potentially putting the government in a federal budget deficit. Another potential cause is the government investing more in infrastructure such as roads, buildings, and bridges. This helps the supply-side of the economy, but is very expensive and can likely cause the federal budget to be in a deficit.

Fig. 1 - U.S. Budget Deficits. Source: DataLab¹

The chart above looks at the United States' budget deficit from 2001 to 2021. As you can see, the United States has only been in a budget surplus once in two decades! Also noteworthy is how large the deficits are when there are large downturns in the economy — 2008 and 2020 respectively.

Government Budget Surplus

Understanding the government budget deficit will make understanding the federal budget surplus easier. We can start with the budget balance equation once more.

Government Budget Surplus: Equation

$$\begin{gathered} S_{Government}=T-G-TR \\ Where:\hspace{0.17em} \\ S:\hspace{0.17em}Savings \\ T:\hspace{0.17em}TaxRevenue \\ G:\hspace{0.17em}GovernmentSpending \\ TR:\hspace{0.17em}GovernmentTransfers \end{gathered}$$

What does the budget balance equation above tell us? A budget surplus will occur if tax revenue is greater than the combined total of government spending and transfers — this will result in a positive budget balance. Let's look at a brief example below where we need to determine whether the budget is in a surplus or a deficit:

Government Budget Surplus: Causes

Depending on the fiscal policy, a government may be more likely to be in a federal budget surplus for the fiscal year. Contractionary Fiscal Policy will tend to increase federal budget surpluses and decrease federal budget deficits due to its lower spending and higher taxes.

A government may prefer a federal budget surplus during "good times" — unemployment is low, production is high, and competition is rampant! The government is increasing its output and revenues during this time. Here, the government will want to spend less since its revenues are so high. This can offset a future federal budget deficit that may be prompted during a recession. A federal budget surplus can also increase trust from other governments since federal budget surpluses are perceived as fiscally responsible. Maintaining trust in a government's financial institutions is very important — who will engage in trade or loan with the United States if no one trusts them?

Balanced Government Budget

Our last application of the government budget will come in the form of a balanced budget.

Balanced Government Budget: Equation

Let's take one final look at our budget balance equation:

$$\begin{gathered} S_{Government}=T-G-TR \\ Where:\hspace{0.17em} \\ S:\hspace{0.17em}Savings \\ T:\hspace{0.17em}TaxRevenue \\ G:\hspace{0.17em}GovernmentSpending \\ TR:\hspace{0.17em}GovernmentTransfers \end{gathered}$$

What does the budget balance equation above tell us? A balanced budget will occur if tax revenue is equal to the combined total of government spending and transfers. Let's look at a brief example below:

Balanced Government Budget: Causes

There is no specific policy that will perfectly balance the budget, but properly utilizing fiscal policy can help governments come close to doing so. In contrast, improper use of fiscal policy will make it difficult to balance the budget. Contractionary fiscal policy during a recession may make things worse!

The cause for a balanced budget is not as clear as a surplus or deficit. Economists tend to agree that a balanced budget is not the most desirable outcome for a government long term since it undermines automatic stabilizers. Economists generally believe that a budget should only be balanced on average, leaving room for deficits in "bad times" and surpluses in "good times." Everything in moderation!

Fig. 2 - Calculating a Budget

Impacts of Government Budget on the Economy

The impact of government budget on the economy is grand. In particular, prolonged federal budget deficits can cause problems for an economy. We will discuss two potential issues here.

Impacts of Government Budget on Economy: Crowding Out

Crowding Out can occur when a government borrows excessively to cover its spending. High government borrowing will make it more difficult for private businesses and individuals to borrow since they are competing for loans — this will cause interest rates to rise. This can lower private investment which can inhibit long-term growth, defeating the purpose of government spending. While the government's actions are sincere enough, there is a danger to prolonged government spending in an economy.

Impacts of Government Budget on the Economy: Defaulting on Debt

There are two options when the government borrows money: pay it off through tax revenue and lower spending, or continue borrowing on your debt. Of course, paying off debt is the obvious option, but what if the government is going through a major recession and they continue to borrow on their debt? What are the potential impacts?

The National Debt is the accrued federal borrowing from the previous fiscal years. If the government continues borrowing at high rates, it keeps adding to the national debt year after year. Adding to the problem are interest payments; interest payments will increase if the debt accrued is substantial. This vicious cycle continues until the government is burdened with a glut of debt. Eventually, the government will have no choice but to default on its debt, causing immense harm to its economy.