Table of Contents

Budget Deficit: Definition, Causes & Effects

What is a Budget Deficit

A budget deficit occurs when the government spends more than it receives through taxation. For example, if it receives $2 trillion in tax receipts, but spends $2.5 trillion on public services – it has a budget deficit of $500 billion. In other words, the amount it spends over and above its income is known as the budget deficit.

Budget deficits are paid for by credit, or existing funds and savings. Governments may be able to use funds from previously generated surpluses, or, they will have to borrow the money from the public. If government wants to fund a new public works program, it will either have to tax more, or, reduce spending elsewhere. No matter what, as long as governments spend more than they receive, they are operating under a budget deficit.

Key Points

A Budget Deficit is where there is a negative difference between income and spending.
The budget deficit is usually linked to the government, but individuals also have a budget deficit if they spend more than they receive.
A long-term budget deficit requires constant growth in order to finance an ever increasing amount of debt.

When expenditures are less than the income received, this is known as a budget surplus – something that has been uncommon among governments in recent decades. It is crucial not only for governments but also for households to maintain a period of budget surpluses. This is because there will be times when a budget deficit will occur, such as – periods of economic recession, times of war, or crumbling public infrastructure. In such cases, it is important to have saved through a budget surplus so that such intervention can be afforded.

Effects of Budget Deficit

Some of the main effects of a budget deficit include:

Crowding Out Effect
Increased Debt
Higher Interest Rates
Higher Interest Payments
Short-term Economic Growth

1. Crowding Out Effect

Budget deficits generally come with high levels of debt as governments struggle to bring in enough money to cover expenditures. What this does is attract investment in government bonds and other forms of denominated debt. However, this takes investment and loans away from private institutions and towards government instead. So in turn, it makes it more difficult for small and medium companies to access the same level of credit that they may obtain otherwise.

2. Increased Debt

One effect of a budget deficit is that it increases the governments debt. When the government spends more than it receives, it must pay for such expenses. Unless it has accumulated funds from the previous year’s surpluses, it must be funded through debt.

Governments borrow money by issuing bonds to private investors. In the UK, these are known as gilts, and in the US, they are known as Treasury bonds. By issuing these, the government borrows money from the private sector, insurance/pension funds, banks, households, and overseas investors.

When running a budget deficit, the government owes an increasing amount to the likes of banks and pension funds. In turn, it must borrow more money to continue to fund the budget deficit. However, the more the government borrows, the less supply there is for private institutions. In other words, the banks and other institutions have fewer funds to lend to the government as they have already lent them billions. As a result, governments must offer higher interest rates – which can increase debt further.

Source: U.S. Office of Management and Budget, Federal Surplus or Deficit [-] [FYFSD], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FYFSD

3. Higher Interest Rates

As the government borrows more, it takes more cash away from the private sector. For example, at a rate of 1 percent, only 100 people may be willing to lend money to the government. If the government wants to raise more money, it has to attract more people willing to lend. It does this by increasing the interest they are willing to pay. For instance, by increasing the rate to 2 percent, there may be twice as many people willing to lend to the government.

The consequence of such is that the more government runs a deficit, the more it must borrow. The more it borrows, the higher interest it will have to pay. The higher interest it has to pay, the higher the debt pile becomes. As a result, consistent budget deficits can, therefore, end up spiralling into greater levels of debt.

4. Higher Interest Payments

When the government runs a budget deficit, it must borrow money. It must also pay interest on these debts. In the same way we pay interest on our mortgages, government pays interest on its debt.

This adds to the existing debt pile, with the US now spending over $389 billion on interest payments alone. As the budget deficit continues, interest payments grow in a vicious cycle that increases the deficit further.

Source: U.S. Department of the Treasury. Fiscal Service, Federal Debt: Total Public Debt [GFDEBTN], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GFDEBTN

5. Short-term Economic Growth

When the government runs a budget deficit, it may stimulate ‘aggregate demand’. They may do so during a recession, in order to boost the economy. For instance, when a recession hits, demand declines as people lose jobs and have less money to spend. Governments may look to step in and create artificial demand in order to prevent a deep economic downturn.

Governments look to soften that blow by increasing spending. That spending goes into the pockets of households, with governments hoping that they spend and increase aggregate demand – thereby softening the negative effects of the recession.

When the government spends more, it takes away money from the private sector. It then uses this to hire people and create new demand. Hiring people gives them money, with that money then being spent in the economy. In the short-term, this can stimulate economic activity. However, in the long-term, it can prove to be a drag on growth. This is because today’s expenditure will have to be paid for by the taxpayer of tomorrow.

Government spending is incredibly sticky. When it increases, it is very difficult to decrease again. So when governments spend more, it usually stays that way. This is because it’s incredibly difficult, politically, to cut jobs or social security.

What results is the confiscation of funds from the private sector. So while $10 billion in government spending may create employment for 1,000 people – it comes at the cost of starving the private sector of investment. These same funds could have been used by the private sector to invest in new and more efficient machinery, whilst also increasing employment in the long-term.

Causes of Budget Deficit

Causes of the budget deficit include:

Politics
Keynesian Fiscal Deficits
Cyclical Reasons
Interest Payments

1. Politics

Politics is one of the main causes of a budget deficit. When government spends more than it receives, it must make difficult political decisions. It has to increase taxation, reduce spending, or just carry on borrowing – increasing the debt further.

Any one of these will prove unpopular with voters. However, carrying on with the deficit is the best short-term solution. As the debt piles up, it will become a problem for the next government instead. By contrast, increasing taxation or reducing public spending will hurt the current government in the short-term.

“When government spends more than it receives, it must make difficult political decisions – increase taxation, reduce spending, or just carry on borrowing.”

Governments also frequently use budget deficits in the run-up to an election. A boost in spending can stimulate the economy and improve the government’s public image. However, due to political factors, the government must continue to spend continues after the election, and so the cycle repeats. And while some governments try to resist – they still have to win votes.

2. Keynesian Fiscal Deficits

Politics is a strong cause of the budget deficit. However, the idea that government spending can stimulate growth also plays its part. The idea, originating from John Maynard Keynes, has been around since before the Second World War.

The idea is that if the government spends, it creates demand, thereby stimulating the economy. This can work in the short term. In fact, it was only originally designed to be implemented during periods of economic decline. However, it is now used as a way to speed up economic growth. The problem with this is that it starves out more efficient private investors.

The more governments borrow and spend, the fewer funds are available to private enterprises to invest in the wider economy. We then come to the question of whether the money is spent more wisely by government officials or by private enterprise.

3. Cyclical Reasons

During periods of economic contraction, government revenues can decrease rapidly, as seen during the 2008 financial crisis.

While revenues drop due to people losing their jobs, costs also rise from increased unemployment benefits and income support. So incomes fall and spending increases simultaneously. This provides a strong force that causes a budget deficit.

4. Interest Payments

If a country runs a continued budget deficit, its debt can pile up. And as it piles up, the amount it has to pay in interest invariably increases, which, in turn, can cause a budget deficit.

For example, the US paid $389 billion in interest alone in 2019. That is about 33 percent of its overall budget deficit. This works in a vicious cycle that continues to create future budget deficits.

How Government Reduces the Budget Deficit

1. Higher Future Taxes

In order to close the budget deficit, governments need to reduce the gap between income and expenditure. If it keeps its expenditure consistent, it will have to raise taxes. It can do that in a direct or in-direct manner.

It can directly increase taxes by just adopting a higher rate. Income taxes may increase by 1 percent to reduce the deficit. However, there are a number of other alternatives that governments could use – each with a different effect. For example, it could increase property or land use taxes, inheritance taxes, payroll taxes, or consumption taxes among others.

Governments can indirectly increase taxes by using inflation to erode income brackets. For example, the existing tax bracket may have a rate of 20 percent on incomes up to $40,000. After a few years of inflation, millions could be taken up into the next higher bracket. If the brackets fail to increase in line with inflation, more and more people will face higher tax rates.

2. Lower Government Spending

After the 2008 recession, Europe pursued a policy of fiscal tightening. As jobs were lost and businesses went bust, tax revenues fell – causing a massive budget deficit. Governments had to choose between continuing to pile up debt or reduce unnecessary spending. In the case of Europe, it decided to choose the latter.

During the financial crisis, countries like Greece, Italy, and Spain had a budget deficit in excess of 10 percent. These countries had overspent for years and the crisis was made worse by their inability to run budget surpluses that would negate such downturns.

Reduced government spending was virtually forced upon them by the EU – particularly Greece. In fact, a study by the IMF found evidence to support this path as the best method for economic recovery. It concluded that cutting spending is less harmful to growth than raising taxes. With the IMF lending Greece billions of Euros, it became part of the criteria for securing a cheap loan. As a result of such drastic measures, Greece now posts a budget surplus, but has had to make significant cuts to government spending.

3. They Don’t! They Default!

On rare occasions, governments do not close up the budget deficit; allowing it to pile up masses amount of debt. Unless they print more money and consequently inflate their way out, they will have to default. In the modern world, it is uncommon for a full default to occur. Rather, payments are delayed further, or the debt is reduced.

When a government bond is due to expire, it is just extended rather than paid. It’s in neither side’s interest to cause an official default. What happens as a result is usually what is referred to as a ‘haircut’. The lenders want to recoup as much money as they can, but know harsh conditions will impact a nation’s ability to pay. At the same time, the nation wants to pay as little as possible as it is struggling with its other commitments.

In Greece for example, the government failed to pay its 1.55 billion Euro loan to the IMF in 2015. This was after it had already succeeded in negotiating a 50 percent haircut on its private debt. The haircut was essentially a default, but only on a percentage of the debt. It no longer had to pay 50 perfect of the debt that was due.

By defaulting on part of the debt, Greece was able to firstly reduce the amount it needs to pay each year, but also on the interest. In turn, this also helped reduce the massive budget deficit it had been running for decades.

FAQs on Budget Deficit

What is meant by budget deficit?

A budget deficit is where the government spends more money than it receives through taxation.

What is the cause of a budget deficit?

The two main causes of a budget deficit are excessive government spending and low levels of taxation that don’t cover expenditure. Tax cuts can cause declines in revenue can result in a budget deficit, or, a massive fiscal stimulus can increase government spending over and above the income it receives.

How does a budget deficit affect the economy?

A budget deficit will tend to increase overall government debt. In turn, as government debt rises, so too do interest rates. As government borrows more, it needs to offer higher rates to attract investors. This is because a higher debt increases the likelihood of a potential default. Consequently, this can also cause a drag on public services which may have to be cut back.

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.