Deficit

Public finance
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Sources of government revenue
Tax and non-tax revenue
Government policy
Fiscal · Monetary · Trade · Policy mix
Fiscal policy
Tax policy (see taxation series)
Government revenue · Government debt
Government spending (Deficit spending)
Budget deficit and surplus
Monetary policy
Money supply · Central bank
Gold standard · Fiat currency
Trade policy
Balance of trade · Tariff · Tariff war
Free trade · Trade pact
See also
Taxation series · Project

A budget deficit occurs when an entity spends more money than it takes in.[1] The opposite of a budget deficit is a budget surplus.

An accumulated governmental deficit over several years (or decades) is referred to as the government debt. Government debt is usually financed by borrowing, although if a government's debt is denominated in its own currency it can print new currency to pay debts. Monetizing debts, however, can cause rapid inflation (but does not necessarily do so) if done on a large scale. Governments can also sell assets to pay off debt. Most governments finance their debts by issuing long-term government bonds or shorter term notes and bills, often sold by auction.

Governments usually must pay interest on what they have borrowed. Governments reduce debt when their revenues exceed their current expenditures and interest costs. Otherwise, government debt increases, requiring the issue of new government bonds or other means of financing debt, such as asset sales.

According to Keynesian economic theories, running a fiscal deficit and increasing government debt can stimulate economic activity when a country's output (GDP) is below its potential output. When an economy is running near or at its potential level of output, fiscal deficits can cause inflation.

Contents

Primary deficit, total deficit, and debt

The government's deficit can be measured with or without including the interest it pays on its debt. The primary deficit is defined as the difference between current government spending and total current revenue from all types of taxes. The total deficit (which is often just called the 'deficit') is spending, plus interest payments on the debt, minus tax revenues.[2]

Therefore, if _t is a timeframe, G_t is government spending and T_t is tax revenue for the respective timeframe, then

Primary deficit = G_t - T_t

If D_{t-1} is last year's debt, and r is the interest rate, then

Total deficit = G_t + r D_{t-1} - T_t

Finally, this year's debt can be calculated from last year's debt and this year's total deficit:

{D_t} = (1+r)D_{t-1} + G_t - T_t

Economic trends can influence the growth or shrinkage of fiscal deficits in several ways. Increased levels of economic activity generally lead to higher tax revenues, while government expenditures often increase during economic downturns because of higher outlays for social insurance programs such as unemployment benefits. Changes in tax rates, tax enforcement policies, levels of social benefits, and other government policy decisions can also have major effects on public debt. For some countries, such as Norway, Russia, and members of the Organization of Petroleum Exporting Countries (OPEC), oil and gas receipts play a major role in public finances.

Inflation reduces the real value of accumulated debt. If investors anticipate future inflation, however, they will demand higher interest rates on government debt, making public borrowing more expensive.

Structural deficits, cyclical deficits, and the fiscal gap

A government deficit can be thought of as consisting of two elements, structural and cyclical.

At the lowest point in the business cycle, there is a high level of unemployment. This means that tax revenues are low and expenditure (e.g. on social security) high. Conversely, at the peak of the cycle, unemployment is low, increasing tax revenue and decreasing social security spending. The additional borrowing required at the low point of the cycle is the cyclical deficit. By definition, the cyclical deficit will be entirely repaid by a cyclical surplus at the peak of the cycle.

The structural deficit is the deficit that remains across the business cycle, because the general level of government spending is too high for prevailing tax levels. The observed total budget deficit is equal to the sum of the structural deficit with the cyclical deficit or surplus.

Some economists have criticized the distinction between cyclical and structural deficits, contending that the business cycle is too difficult to measure to make cyclical analysis worthwhile.

The fiscal gap, a measure proposed by economists Alan Auerbach and Lawrence Kotlikoff, measures the difference between government spending and revenues over the very long term, typically as a percentage of Gross Domestic Product. The fiscal gap can be interpreted as the percentage increase in revenues or reduction of expenditures necessary to balance spending and revenues in the long run. For example, a fiscal gap of 5% could be eliminated by an immediate and permanent 5% increase in taxes or cut in spending or some combination of both.[3] It includes not only the structural deficit at a given point in time, but also the difference between promised future government commitments, such as health and retirement spending, and planned future tax revenues. Since the elderly population is growing much faster than the young population in many countries, many economists argue that these countries have important fiscal gaps, beyond what can be seen from their deficits alone.

National budget deficits (2004)

United States deficit or surplus percentage 1901 to 2006
National Government Budgets for 2004 (in billions of US$)
Nation GDP Revenue Expenditure Exp ÷ GDP Budget Deficit/Surplus[4] Deficit ÷ GDP[4]
US (federal) 11700 1862 2338 19.98% -25.56% -4.07%
US (state) - 900 850 7.6% +5% +0.4%
Japan 4600 1400 1748 38.00% -24.86% -7.57%
Germany 2700 1200 1300 48.15% -8.33% -3.70%
United Kingdom 2100 835 897 42.71% -7.43% -2.95%
France 2000 1005 1080 54.00% -7.46% -3.75%
Italy 1600 768 820 51.25% -6.77% -3.25%
China 1600 318 349 21.81% -9.75% -1.94%
Spain 1000 384 386 38.60% -0.52% -0.20%
Canada (federal) 900 150 144 16.00% +4.00% +0.67%
South Korea 600 150 155 25.83% -3.33% -0.83%

Data are for 2004. [5]

Early deficits

Before the invention of bonds, the deficit could only be financed with loans from private investors or other countries. A prominent example of this was the Rothschild dynasty in the late 18th and 19th century, though there were many earlier examples.

These loans became popular when private financiers had amassed enough capital to provide them, and when governments were no longer able to simply print money, with consequent inflation, to finance their spending.

However, large long-term loans had a high element of risk for the lender and consequently gave high interest rates. Governments later began to issue bonds that were payable to the bearer, rather than the original purchaser. This meant that someone who lent the state money could sell on the debt to someone else, reducing the risks involved and reducing the overall interest rates. Examples of this are British Consols and American Treasury bill bonds.

Ricardian Equivalence

The Ricardian equivalence hypothesis, named after the English political economist and Member of Parliament David Ricardo, states that because households anticipate that current public deficit will be paid through future taxes, those households will accumulate savings now to offset those future taxes. If households acted in this way, a government would not be able to use fiscal policy to stimulate the economy. The Ricardian equivalence result requires assumptions. These include households acting as if they were infinite-lived dynasties as well as assumptions of no uncertainty and no liquidity constraints. Also, for Ricardian equivalence to apply, the deficit spending would have to be permanent. In contrast, a one-time stimulus through deficit spending would suggest a lesser tax burden annually than the one-time deficit expenditure. Thus temporary deficit spending is still expansionary. Empirical evidence on Ricardian equivalence effects has been mixed.

Deficit Spending

According to the Keynesian economics school of thought (and related movements), Governments can attempt to stimulate the economy by intentionally running a deficit.

See also

References

  1. ↑ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 403. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 
  2. ↑ Michael Burda and Charles Wyplosz (1995), European Macroeconomics, 2nd ed., Ch. 3.5.1, p. 56. Oxford University Press, ISBN 0198774680.
  3. ↑ http://www.aarp.org/research/blueprint/overstatedproblem/the_fiscal_gap.html AARP article on the fiscal gap
  4. ↑ 4.0 4.1 In this column, a negative number represents a deficit, and a positive number represents a surplus.
  5. ↑ Data on the United States' federal debt can be found at U.S. Treasury website. Data on U.S. state government finances can be found at the National Association of State Budget Officers website. Data for most advanced countries can be obtained from the Organization for Economic Cooperation and Development (OECD) website. Data for most other countries can be found at the International Monetary Fund (IMF) website.

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