Budget Deficit

What is a Budget Deficit?

A budget deficit occurs when expenses exceed revenue and indicate the financial health of a country. The government generally uses the term budget deficit when referring to spending rather than businesses or individuals. Accrued deficits form national debt.

A budget deficit is a financial loss for during a period where expenses exceed revenues. This concept is often used in business but more commonly used to refer to governmental spending in excess of revenues collected.

What Does Budget Deficit Mean?

A deficit is a state of financial health that affects a large variety of businesses, organizations, and governments. These organizations include a wide specter of professionals that all must monitor their budgets: accountants, business owners, financial professionals, governmental figures, and many more. One of the most famous budget deficits is that of the United States government, but the most common is by ordinary businesses that are mismanaged or poorly executed.

A deficit must be paid. If it isn’t, then it creates debt. Each year’s deficit adds to the debt. As the debt grows, it increases the deficit in two ways. First, the interest on the debt must be paid each year. This increases spending while not providing any benefits. Second, higher debt levels can make it more difficult to raise funds. Creditors become concerned about the borrower’s ability to repay the debt. When this happens, the creditors demand higher interest rates to provide a greater return on this higher risk. That further increases each year’s deficit.

Budget Surplus vs. Deficit: What’s the Difference?

If the government’s revenue exceeds expenses, it creates a budget surplus (the opposite of a budget deficit). As such, the government will have extra funds to allocate for a wide range of uses, including paying off debts, reducing taxes, funding public programs, and so on. The additional capital can also be saved to spend in the future when another budget deficit occurs.

Components of Budget Deficit

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.

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 = Total Government Spending – Total Government Income

Budgetary deficit is the sum of revenue account deficit and capital account deficit. If revenue expenses of the government exceed revenue receipts, it results in revenue account deficit. Similarly, if the capital disbursements of the government exceed capital receipts, it leads to capital account deficit. Budgetary deficit is usually expressed as a percentage of GDP.

Generally speaking, it’s only possible to reduce the budget deficit by increasing revenue or decreasing spending. This can be achieved by increasing the country’s economic growth rate or raising taxes. However, it’s a tricky tightrope to walk, since excessive taxes can slow growth. Cutting spending can also be a complicated issue, as deep spending cuts can slow down economic growth, reducing revenues and potentially creating an even larger budget deficit.

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.

The Danger of Budget Deficits

One of the primary dangers of a budget deficit is inflation, which is the continuous increase of price levels. In the United States, a budget deficit can cause the Federal Reserve to release more money into the economy, which feeds inflation. Ultimately, a recession will occur, which represents a decline in economic activity that lasts for at least six months. Continued budget deficits can lead to inflationary monetary policies, year after year.

Financing Deficits

Most governments prefer to finance their deficits instead of balancing the budget. Government bonds finance the deficit. Most creditors think that the government is highly likely to repay its creditors. That makes government bonds more attractive than riskier corporate bonds. As a result, government interest rates remain relatively low. That allows governments to keep running deficits for years.

The United States finances its deficit with Treasury bills, notes, and bonds. That’s the government’s way of printing money. It is creating more credit denominated in that country’s currency. Over time, it lowers the value of that country’s currency. As bonds flood the market, the supply outweighs the demand.

Many countries, including the United States, are able to print their own currency. As bills come due, they simply create more credit and pay it off. That lowers the value of the currency as the money supply increases. If the deficit is moderate, it doesn’t hurt the economy. Instead, it boosts economic growth.

The United States benefits from its unique position. The U.S. dollar functions as a global currency. It’s used for most international transactions. For example, almost all oil contracts are priced in dollars. As a result, the United States can safely run a larger debt than any other country.

The consequences aren’t immediate. Creditors are satisfied because they know they will get paid. Elected officials keep promising constituents more benefits, services, and tax cuts. Telling them they will get less from the government would be political suicide. As a result, most presidents increased the budget deficit.

It becomes a self-defeating loop, as countries take on new debt to repay their old debt. Interest rates on the new debt skyrockets. It becomes ever more expensive for countries to roll over debt. If it continues long enough, a country may default on its debt. That’s what caused the Greek debt crisis in 2009.

Advantages and Disadvantages of a Budget Deficit

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