How often do you make a budget for yourself and stick to it? What are the consequences of failing to follow your budget? Depending on your circ*mstances, failing to stay within your budget can be trivial or consequential. Similar to yourself, the government also has a budget that it tries to balance for an entire country! However, it won't always be successful and could lead to a deficit. Want to learn more about what occurs during a budget deficit? Read on!
Budget Deficit Definition
Let's go over the definition of a budget deficit. A budget deficit occurs when the government's tax revenues are less than its spending for a particular year. In contrast, a budget surplus occurs when the government's tax revenues are greater than its spending for a particular year. A budget deficit will occur if there is high government spending and low tax revenue. After the fiscal year, any deficit the government has will be added to the national debt. The fact that deficits add to the national debt is a reason why many argue against prolonged deficits. However, if this is the case, why argue for a budget deficit ever?
If the government utilizes an expansionary fiscal policy, then a budget deficit will likely occur. Expansionary fiscal policy will increase government spending and lower taxes to boost aggregate demand. This is desirable to address recessions, but will likely push the budget into a deficit. Therefore, it can be difficult to follow the rule of avoiding a deficit at all costs. If governments did follow this rule of thumb, then there would be no action during recessionary periods which could prolong the recession itself.
As you can see, there is no one "right" answer to the budget. Governments have to make difficult decisions based on the circ*mstances they are given at that point in time.
Budget deficits occur when the government's tax revenues are less than its spending for a particular year.
Budget surpluses occur when the government's tax revenues are greater than its spending for a particular year.
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:
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.
The economy is in a recession and the government has to utilize expansionary fiscal policy. This will help address the recession but may increase the deficit by a large amount. The government is asking for your help to calculate what the deficit will be after this policy. The tax revenues are estimated to be $50 million, and the spending is estimated to be $75 million.
First, set up the formula:
Next, plug in the numbers:
Lastly, calculate.
We can say that given the numbers supplied by the government, the deficit will be $25 million after utilizing expansionary fiscal policy.
It's always helpful to begin your calculation by writing down the formula you will be using!
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.
Budget Deficit Economics
Let's discuss the budget deficit in economics. A budget deficit can have many impacts on the economy, both good and bad. Let's look at a few of them.
Budget Deficit Economics: 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.
Crowding Out occurs when the government needs to borrow from the loanable funds market to finance their increased government spending, leading to increased interest rates for private businesses.
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!
Ways to reduce Budget Deficit
Let's look over some ways that the government can reduce a budget deficit.
Ways to Reduce 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.
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.
The current budget deficit is $100 million. Government spending is $150 million and tax revenues are $50 million. If the government increases taxes to receive an additional $50 in tax revenue, how will the budget deficit be affected?
Therefore, the budget deficit decreased by $50 million after the tax increase.
Now let's take a look at the other way to reduce the budget deficit.
Ways to Reduce 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:
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.
The current budget deficit is $150 million. Government spending is $200 million and tax revenues are $50 million. If the government decreases government spending taxes by $100 million, how will the budget deficit be impacted?
Therefore, the budget deficit will decrease by $100 million after the decrease in government spending.
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.
Budget Deficit - Key takeaways
- Budget deficits occur when the government's tax revenues are less than its spending for a particular year.
- Budget surpluses occur when the government's tax revenues are greater than its spending for a particular year.
- The formula for calculating the budget deficit is the following: Budget Deficit = Government Spending – Tax Revenues
- Crowding out and defaulting on debt are possible outcomes of prolonged budget deficits.
- The government can reduce budget deficits by increasing taxes or by lowering government spending.
References
- Congressional Budget Office, Budget and Economic Data, https://www.cbo.gov/data/budget-economic-data#11
