Government budget balance

A government budget is a financial statement presenting the government's proposed revenues and spending for a financial year. The government budget balance, also alternatively referred to as general government balance,[1] public budget balance, or public fiscal balance, is the overall difference between government revenues and spending. A positive balance is called a government budget surplus, and a negative balance is a government budget deficit. A budget is prepared for each level of government (from national to local) and takes into account public social security obligations.

The government budget balance is further differentiated into the primary balance and the structural balance (also known as cyclically-adjusted balance). The primary budget balance equals the government budget balance before interest payments. The structural budget balances attempts to adjust for the impacts of the real GDP changes in the national economy.

Sectoral balances

The government fiscal balance is one of three major sectoral balances in the national economy, the others being the foreign sector and the private sector. The sum of the surpluses or deficits across these three sectors must be zero by definition. For example, if there is a foreign financial surplus (or capital surplus) because capital is imported (net) to fund the trade deficit, and there is also a private sector financial surplus due to household savings exceeding business investment, then by definition, there must exist a government budget deficit so all three net to zero. The government sector includes federal, state and local governments. For example, the U.S. government budget deficit in 2011 was approximately 10% GDP (8.6% GDP of which was federal), offsetting a capital surplus of 4% GDP and a private sector surplus of 6% GDP.[2]

Financial journalist Martin Wolf argued that sudden shifts in the private sector from deficit to surplus forced the government balance into deficit, and cited as example the U.S.: "The financial balance of the private sector shifted towards surplus by the almost unbelievable cumulative total of 11.2 per cent of gross domestic product between the third quarter of 2007 and the second quarter of 2009, which was when the financial deficit of US government (federal and state) reached its peak...No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust."[2]

Economist Paul Krugman also explained in December 2011 the causes of the sizable shift from private deficit to surplus: "This huge move into surplus reflects the end of the housing bubble, a sharp rise in household saving, and a slump in business investment due to lack of customers."[3]

The sectoral balances (also called sectoral financial balances) derive from the sectoral analysis framework for macroeconomic analysis of national economies developed by British economist Wynne Godley.[4]

Sectoral financial balances in U.S. economy 1990–2012. By definition, the three balances must net to zero. Since 2009, the U.S. capital surplus and private sector surplus have driven a government budget deficit.

GDP (Gross Domestic Product) is the value of all goods and services produced within a country during one year. GDP measures flows rather than stocks (example: the public deficit is a flow, measured per unit of time, while the government debt is a stock, an accumulation). GDP can be expressed equivalently in terms of production or the types of newly produced goods purchased, as per the National Accounting relationship between aggregate spending and income:

where Y is GDP (production; equivalently, income), C is consumption spending, I is private investment spending, G is government spending on goods and services, X is exports and M is imports (so X – M is net exports).

Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:

where S is total saving and T is total taxation net of transfer payments.

Combining the two perspectives gives

Hence

This implies the accounting identity for the three sectoral balances – private domestic, government budget and external:

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G, minus net taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net spending of non-residents on this country's production. Another way of saying this is that total private savings is equal to private investment plus the public deficit plus net exports.

In macroeconomics, the Modern Money Theory describes any transactions between the government sector and the non-government sector as a vertical transaction. The government sector includes the treasury and the central bank, whereas the non-government sector includes private individuals and firms (including the private banking system) and the external sector – that is, foreign buyers and sellers.[5]

In any given time period, the government’s budget can be either in deficit or in surplus. A deficit occurs when the government spends more than it taxes; and a surplus occurs when a government taxes more than it spends. Sectoral balances analysis shows that as a matter of accounting, government budget deficits add net financial assets to the private sector. This is because a budget deficit means that a government has deposited more money and bonds into private holdings than it has removed in taxes. A budget surplus means the opposite: in total, the government has removed more money and bonds from private holdings via taxes than it has put back in via spending.

Therefore, budget deficits, by definition, are equivalent to adding net financial assets to the private sector, whereas budget surpluses remove financial assets from the private sector.

This is represented by the identity:

where NX is net exports.

The conclusion drawn from this is that private net saving is only possible if the government runs budget deficits; alternately, the private sector is forced to dissave when the government runs a budget surplus.

According to the sectoral balances framework, budget surpluses remove net savings; in a time of high effective demand, this may lead to a private sector reliance on credit to finance consumption patterns. Hence, continual budget deficits are necessary for a growing economy that wants to avoid deflation. Therefore, budget surpluses are required only when the economy has excessive aggregate demand, and is in danger of inflation. If the government issues its own currency, MMT tells us that the level of taxation relative to government spending (the government's budget deficit or surplus) is in reality a policy tool that regulates inflation and unemployment, and not a means of funding the government's activities per se.

Primary balance

Primary balance is defined by the Organisation for Economic Co-operation and Development (OECD) as government net borrowing or net lending, excluding interest payments on consolidated government liabilities.[6] A federal budget that achieves primary balance has federal revenues equaling spending but with a remaining budget deficit as a result of interest payments on past debt. The Center for American Progress recommended on December 14, 2009 that the United States set as a goal achieving primary balance by 2014.

Primary deficit, total deficit, and debt

The meaning of "deficit" differs from that of "debt", which is an accumulation of yearly deficits. Deficits occur when a government's expenditures exceed the revenue that it generates. The deficit can be measured with or without including the interest payments on the debt as expenditures.[7]

The primary deficit is defined as the difference between current government spending on goods and services and total current revenue from all types of taxes net of transfer payments. The total deficit (which is often called the fiscal deficit or just the 'deficit') is the primary deficit plus interest payments on the debt.[7]

Therefore, if refers to an arbitrary year, is government spending and is tax revenue for the respective year, then

If is last year's debt (the debt accumulated up to and including last year), and is the interest rate attached to the debt, then the total deficit for year t is

where the first term on the right side is interest payments on the outstanding debt.

Finally, this year's debt can be calculated from last year's debt and this year's total deficit, using the government budget constraint:

That is, the debt after this year's government operations equals what it was a year earlier plus this year's total deficit, because the current deficit has to be financed by borrowing via the issuance of new bonds.

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

French government borrowing (budget deficits) as a percentage of GNP, 1960–2009.

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 exceeds 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.[8]

The fiscal gap, a measure proposed by economists Alan Auerbach and Laurence 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.[9]

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 developed countries, many economists argue that these countries have important fiscal gaps, beyond what can be seen from their deficits alone.

National government budgets

Data are for 2010:[10]

National Government Budgets for 2010 (in billions of US$)
Nation GDP Revenue Expenditure Budget Balance[11] Exp/GDP Balance/Revenue Balance/GDP[11]
US (federal) 14,526 2,162 3,456 -1,293 23.8% -59.8% -8.9%
US (state) 14,526 900 850 +32 7.6% +5.6% +0.4%
Japan 4,600 1,400 1,748 +195 38.0% -24.9% +3.6%
Germany 2,700 1,200 1,300 +199 48.2% -8.3% +6.1%
United Kingdom 2,100 835 897 -75 42.7% -7.4% -3.3%
France 2,000 1,005 1,080 -44 54.0% -7.5% -1.7%
Italy 1,600 768 820 -72 51.3% -6.8% -3.5%
China 1,600 318 349 -31 21.8% -9.7% +5.1%
Spain 1,000 384 386 -64 38.6% -0.5% -4.6%
Canada 900 150 144 -49 16.0% +4.0% -3.1%
South Korea 600 150 155 +29 25.8% -3.3% +2.9%

Early deficits

United States deficit or surplus percentage 1901 to 2006.

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 (Peruzzi family).

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.

Deficit spending

According to most economists, during recessions, the government can stimulate the economy by intentionally running a deficit. As Professor William Vickrey, awarded with the 1996 Nobel Memorial Prize in Economic Sciences put it :

"Deficits are considered to represent sinful profligate spending at the expense of future generations who will be left with a smaller endowment of invested capital. This fallacy seems to stem from a false analogy to borrowing by individuals. Current reality is almost the exact opposite. Deficits add to the net disposable income of individuals, to the extent that government disbursements that constitute income to recipients exceed that abstracted from disposable income in taxes, fees, and other charges. This added purchasing power, when spent, provides markets for private production, inducing producers to invest in additional plant capacity, which will form part of the real heritage left to the future. This is in addition to whatever public investment takes place in infrastructure, education, research, and the like. Larger deficits, sufficient to recycle savings out of a growing gross domestic product (GDP) in excess of what can be recycled by profit-seeking private investment, are not an economic sin but an economic necessity. Deficits in excess of a gap growing as a result of the maximum feasible growth in real output might indeed cause problems, but we are nowhere near that level. Even the analogy itself is faulty. If General Motors, AT&T, and individual households had been required to balance their budgets in the manner being applied to the Federal government, there would be no corporate bonds, no mortgages, no bank loans, and many fewer automobiles, telephones, and houses."

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 tax cuts to stimulate the economy. The Ricardian equivalence result requires several 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.

Crowding-out hypothesis

The crowding-out hypothesis is the assumption that when a government experiences a deficit, the choice to borrow to offset that deficit draws on the pool of resources available for investment and private investment gets crowded out. This crowding-out effect is induced by changes in the interest rate. When the government wishes to borrow, their demand for credit increases and the interest rate, or price of credit, increases. This increase in the interest rate makes private investment more expensive as well and less of it is used.[12]

Potential policy solutions for unintended deficits

Increase taxes or reduce government spending

The government surplus/deficit of struggling European countries according to European sovereign debt crisis: Italy, Cyprus, Portugal, Spain, Greece, United Kingdom and Ireland against the Eurozone and the United States (2000–2013).

If a reduction in a structural deficit is desired, either revenue must increase, spending must decrease, or both. Taxes may be increased for everyone/every entity across the board or lawmakers may decide to assign that tax burden to specific groups of people (higher-income individuals, businesses, etc.) Lawmakers may also decide to cut government spending.

Like with taxes, they could decide to cut the budgets of every government agency/entity by the same percentage or they may decide to give a greater budget cut to specific agencies. Many, if not all, of these decisions made by lawmakers are based on political ideology, popularity with their electorate, or popularity with their donors.

Changes in tax code

Similar to increasing taxes, changes can be made to the tax code that increases tax revenue. Closing tax loopholes and allowing fewer deductions are different from the act of increasing taxes but essentially have the same effect.

Reduce debt service liability

Every year, the government must pay debt service payments on their overall public debt. These payments include principal and interest payments. Occasionally, the government has the opportunity to refinance some of their public debt to afford them lower debt service payments. Doing this would allow the government to cut expenditures without cutting government spending.[13]

suggest a balanced budget

A balanced budget is a practice that sees a government enforcing that payments, procurement of resources will only be done inline with realised revenues, such that a flat or a zero balance is maintained. Surplus purchases are funded through increases in tax.

See also

U.S.-specific

References

  1. ↑ "IMF database". Imf.org. 2006-09-14. Retrieved 2013-02-01.
  2. 1 2 Financial Times-Martin Wolf-The Balance Sheet Recession in the U.S. – July 2012
  3. ↑ NYT-Paul Krugman-The Problem-December 2011
  4. ↑ Goldman's Top Economist Explains The World's Most Important Chart, And His Big Call For The US Economy
  5. ↑ "Deficit Spending 101 – Part 1 : Vertical Transactions" Bill Mitchell, 21 February 2009
  6. ↑ "OECD Glossary of Statistical Terms: Primary Balance". stats.oecd.org. Retrieved August 14, 2011.
  7. 1 2 Michael Burda and Charles Wyplosz (1995), European Macroeconomics, 2nd ed., Ch. 3.5.1, p. 56. Oxford University Press, ISBN 0-19-877468-0.
  8. ↑ Dillow, Chris (15 February 2010). "The myth of the structural deficit". Investors Chronicle. The Financial Times Limited. Retrieved 19 May 2013.
  9. ↑ AARP article on the fiscal gap
  10. ↑ 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.
  11. 1 2 In this column, a negative number represents a deficit, and a positive number represents a surplus.
  12. ↑ Harvey S. Rosen (2005), Public Finance, 7th Ed., Ch. 18 p. 464. McGraw-Hill Irwin, ISBN 0-07-287648-4
  13. ↑ Steven A. Finkler (2005), Financial Management For Public, Health And Not-For-Profit Organizations, 2nd Ed., Ch. 11, pp. 442–43. Pearson Education, Inc, ISBN 0-13-147198-8.
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