Question

The U.S. has run a budget deficit every year in recent memory. What is a budget deficit, and what are the implications of a budget deficit? Why might policies intending to reduce the budget deficit actually increase it?

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.

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.

Implications of a budget deficit:

• Increased borrowing
• Higher debt interest payments
• Higher Taxes and lower spending
• Increased Interest rates
• Crowding Out
• Inflation

Below are the reasons why policies on budget deficit may not always help

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.

Spending cuts have contributed to a decline in economic growth, leading to lower tax revenues and rising debt to GDP. These spending cuts have been much less effective in reducing the budget deficit because these countries can’t devalue , they can’t pursue a loosening of monetary policy.

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.

A bailout usually comes with strict instructions on reducing the deficit – this may be politically easier when it is enforced from the outside. However, in the case of severely indebted countries, a bailout may be insufficient to deal with the underlying level of debt. Also, bailout conditions can be highly controversial.

To reduce fiscal deficits, the government is likely to use a combination of policies. A key factor is the timing of deficit reduction plans. If the country is already in recession, it is much more difficult to reduce the deficit because fiscal consolidation tends to worsen the economic situation leading to lower tax revenues. In some cases, austerity can even be self-defeating.

The best way to reduce the budget deficit is to aim for positive economic growth, but in the long-term evaluate government spending commitments and reduce spending to sustainable levels.