Budget Deficit

What is a Budget Deficit?

A budget deficit occurs when government expenditures exceed revenues from taxes and other sources. Although the concept of a budget deficit applies to any organization with operating revenues and expenses, the term is most commonly applied to government budgets.

Public savings are also referred to as budget surplus. When public savings are negative, the government is said to be running a budget deficit. To spend more than tax revenues allow, governments borrow money and run budget deficits, which are financed by borrowing.

The amount borrowed is added to the nation’s national debt. For example, the national debt of the United States is estimated at $23 trillion as of 2020. As of February 2020, the country’s federal budget shortfall amounts to $625 billion.

Budget Deficit – Components

1. Revenues

For national governments, a majority of revenue comes from income taxes, corporate taxes, consumption taxes, and social insurance taxes. For non-governmental organizations and companies, revenues come from the sale of goods and services.

2. Expenses

For governments, expenses include government spending on healthcare, infrastructure, defense, subsidies, pensions, and other items that contribute to the health of the overall economy. For non-governmental organizations and companies, expenses include the amount that is spent on daily operations and factors of production, including rent and wages.

Budget Deficit – Implications

Contrary to what it may sound like, a budget deficit is not always a negative indicator of economic health. Some of the implications of a budget deficit are described below:

1. Increase aggregate demand

A budget deficit implies a reduction in taxes and an increase in government spending, which results in an increase in the aggregate demand of the country and subsequent economic growth, ceteris paribus.

2. Boost the economy during a recession

During a recession, the economy tends to experience a decrease in investment spending from the private sector, along with lower aggregate consumption and demand. A government may choose to borrow and run a deficit to combat the situation by taking measures to spend effectively.

3. Increase government spending

Government spending serves many purposes, including investments in infrastructure, healthcare, human capital, unemployment benefits, pension programs, and so on. A nation’s government may choose to spend more than its revenues allow by running a deficit.

4. Fiscal policy

A budget deficit may be used to finance an expansionary fiscal policy, which involves lowering income and corporate taxes (therefore reducing revenue for the government) and increasing government spending on infrastructure and investments to attract foreign capital and boost economic growth.

5. Higher taxes in the future

A current budget deficit that runs persistently often implies that the government will need to increase taxes in the future to pay off the accumulated debt since taxes are one of the primary sources of revenue for the government.

6. Higher interest rates and bond yields

In order to borrow large amounts, governments often offer higher interest rates to investors and international banks that lend them money. Increased government borrowing results in higher interest rates and bond yields since investors and banks require compensation for the risk through interest payments.

Budget Deficit – Theories

1. Ricardian Equivalence Theory

The Ricardian Equivalence Theory argues that using budget deficit or borrowing to stimulate the economy exerts no effect. It relies on many assumptions, including one that states that the government will increase taxes to pay off the current deficit.

According to the theory, households take it into account while making investment and saving decisions and choose to save more to compensate for the future increase in taxes. Therefore, consumption in the economy decreases, and the increase in government spending financed by a deficit does not impact the economy.

2. Crowding Out Theory

The Crowding Out Theory states that an increase in government spending and borrowing leads to a decrease in investments from the private sector. It is because governments borrow by selling bonds to the private sector and by borrowing from foreign sources, such as other countries and international banks.

However, it often results in higher interest rates, as well as higher spending on bonds by the private sector – which leads to lower funds for private sector investments and a higher cost of borrowing (due to higher interest rates).

Therefore, the increase in government spending is often met with a relatively smaller decrease in private sector investments, which offsets the overall effect of the expansionary move.

Additional Resources

Economic Indicators

Balanced Budget

Economic Recovery Tax Act of 1981 (ERTA)

Government Spending

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