Question

How budget deficits and national debt are defined?

Is it a good policy for the government to create budget deficit? Why and why not?

Answer 1

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 happens when current expenses exceed the amount of income received through standard operations.

Certain unanticipated events and policies may cause budget deficits.Countries can counter budget deficits by raising taxes and cutting spending.The national debt is the public and intragovernmental debt owed by the federal government. It’s also called sovereign debt, country debt, or government debt.It consists of two types of debt.The first is debt held by the public.The government owes this to buyers of its bonds.Those buyers are the country’s citizens, international investors, and foreign governments.The second type is intragovernmental debt. The federal government owes this to other government departments. It often funds government and citizens’ pensions. An example is the U.S. Social Security retirement account.

The federal government adds to the debt whenever it spends more than it receives in tax revenue. Each year's budget deficit gets added to the debt. Each budget surplus gets subtracted.A budget deficit occurs when a government spending is greater than tax revenues. This leads to an accumulation of public sector debt. If the deficits are unsustainable, this can cause rising bond yields (higher interest payments) and in the worse case, lead to a loss of confidence in the government. Though this is quite rare for countries with their own currency.The obvious way to reduce a budget deficit is to increase tax rates and cut government spending. However, the difficulty is that this fiscal tightening can cause lower economic growth – which in turn can cause a higher cyclical deficit (government get less tax revenue in a recession). The best way to reduce fiscal deficits depends on the situation a country is in.

The government can cut its public spending to reduce its fiscal deficit. For example, in the 1990s, Canada reduced its public spending quite significantly. They evaluated many different departments and cut spending by up to 20% within four years across the board. This proved a successful policy in reducing the budget deficit. During this period of spending cuts, the Canadian economy continued to grow which also helped reduce the budget deficit. However, during the spending cuts, the Canadian economy benefited from lower interest rates to boost spending, higher exports to the US, and a weaker exchange rate. The strong economy made it much easier to cut spending.In the 1920s, the UK cut spending drastically, (known as the Geddes Axe) but, combined with the gold standard (fixed exchange rate), this contributed to deflation and lower growth. Therefore, in this period, the government was relatively unsuccessful in reducing the debt to GDP ratio.

Higher taxes increase revenue and help to reduce the budget deficit. Like spending cuts, they could cause lower spending and lead to a fall in economic growth. Again it depends on the timing of tax increases. In a recession, tax increases could cause a significant drop in spending. During high growth, tax increases won’t harm spending as much. It also depends on the type of tax you increase. Recently, France increased taxes on the rich to over 70% – however, some have complained this is too high and creates disincentives to work in France. If high marginal tax rates do reduce incentives to work, the tax revenue raised may be less than planned.One of the best ways to reduce the budget deficit as a % of GDP is to promote economic growth. If the economy grows, then the government will increase tax revenue, without raising taxes. With economic growth, people pay more VAT, companies pay more corporation tax (tax on profits), and workers pay more income tax. High economic growth, is the least painful way to reduce the budget deficit because you don’t need to raise tax rates or cut spending.