Budget Balance

Balanced Budget definition

Every government must grapple with important decisions about its budget. Depending on the health of the economy and the budget balance, policymakers need to make certain decisions on taxes, spending, and borrowing. But before we get into that, we first need to know what the budget balance is.

Government revenue comes from the taxes it collects from its citizens. Government spending is the money the government spends on goods, services, and transfer payments, such as unemployment insurance and Social Security. Because revenue and spending rarely balance out, the budget balance is usually either in surplus or deficit.

Now that we know the definitions of budget balance like the one in Figure 1, budget surplus, budget deficit, and balanced budget, let's take a look at the formula to calculate the budget balance.

Fig 1. - Balanced Budget

Budget Balance formula

The formula for calculating the budget balance is as follows:

S = T - G - TR

Where:

S = Government Savings (Budget Balance)

T = Tax Revenue

G = Government Purchases of Goods and Services

TR = Transfer Payments

Budget Balance and Fiscal Policy

When the budget balance (S) is positive, it is called a surplus. When the budget balance is negative, it is called a deficit. If the government engages in expansionary fiscal policies (reducing taxes, increasing government purchases, or increasing transfer payments) the budget balance will decline, either from a surplus to a deficit or from a deficit to a larger deficit. On the other hand, if the government conducts contractionary fiscal policies (increasing taxes, reducing government purchases, or reducing transfer payments) the budget balance will increase, either from a deficit to a surplus or from a surplus to a larger surplus.

What happens to the budget balance if the government does nothing? Budget deficits, or shrinking budget surpluses, generally occur during recessions as a decline in employment leads to lower income tax revenue and a decline in demand leads to lower corporate tax revenue, while rising unemployment leads to an increase in transfer payments like unemployment insurance and food subsidies (see Figure 2 below). In contrast, during expansions, budget surpluses, or shrinking budget deficits, generally occur as rising employment leads to higher income tax revenue and an increase in demand leads to higher corporate tax revenue, while falling unemployment leads to a decline in transfer payments (see Figure 3 below). These changes in the budget balance that occur largely outside of fiscal policy are known as automatic stabilizers. Thus, the budget balance can go up or down without policymakers even getting involved.

The bigger question though is, what happens to the economy if the government does nothing? That really depends on how fast and how much the economy is either expanding or contracting. During the 2007-2009 Global Financial Crisis, economies all over the world were deteriorating rapidly. Some say doing nothing would have allowed the economy to "self-correct", as prices would fall so much that eventually, people would start spending again, and as production would fall so much that eventually, companies would start producing again. That may be true, but it may have taken a very long time for this to happen, which may have led to even more jobs lost, further declines in the stock market, and possibly even a second Great Depression. At some point, the government needs to step in if the economy is in freefall. Faster and bigger economic changes require faster and bigger fiscal policies to bring the economy closer to equilibrium, and that's exactly what happened during this period as both central banks and governments around the world took drastic measures to save their economies from disaster.

Fig 2. - U.S Budget Deficit and Recessions - Source: Congressional Budget Office, National Bureau of Economic Research

Fig 3. - U.S. Budget Deficit and Unemployment. Source: Congressional Budget Office

Budget Balance and the Business Cycle

Business cycle effects on the budget balance do not last very long. Over time, recessionary gaps (real GDP below potential output) and inflationary gaps (real GDP above potential output) are eliminated. However, that may not be enough to bring the economy back to equilibrium. In those cases, the government cannot sit idly by and must make decisions on taxes, spending, and borrowing to either lift the economy out of recession or cool it down if it is overheating during an expansion. However, as we shall see shortly, whether the government can fund its spending in the long run is more important than whether it is running a surplus or deficit in the short run.

It is useful to determine what the budget deficit would be if real GDP was equal to potential output. How much more revenue would the government collect and how much less would it spend on transfer payments if a recessionary gap were eliminated (real GDP rose to match potential output)? How much less revenue would the government collect and how much more would it spend on transfer payments if an inflationary gap were eliminated (real GDP fell to match potential output)? This is known as the cyclically-adjusted budget balance, and it doesn't fluctuate as much as the actual budget balance.

Balanced Budget example

Let's take a look at an example budget, what the government can do to bring it back into balance, and how a balanced budget rule would impact the government's actions.

Components of a Balanced Budget

Politicians tend to gravitate toward budget deficits in order to attract voters and satisfy their constituents without having to raise taxes or cut spending. Raising taxes reduces workers' take-home pay while cutting spending can negatively impact their voters, their friends, or themselves. The budget balance is far less of a concern to those with the power to improve it, so very few politicians favor a balanced budget rule.

Most economists don't think a balanced budget rule is a good idea either because it prevents automatic stabilizers (tax revenue and transfer payments) from limiting the severity of recessions or the overheating of expansions. If the budget is in a deficit in the middle of a recession, the only way to get it back to a balanced budget would be to raise taxes, reduce government spending or reduce transfer payments, all of which would make the recession even worse.

The big question is, what is more important, limiting the size of recessions or limiting the size of budget deficits? If government revenue is less than government spending, then to raise the extra revenue needed the government usually borrows the money by issuing debt, which is purchased by investors. The total outstanding federal debt is the accumulation of past federal deficits. If the federal debt continues to rise over time, the burden to pay it off falls to future generations of taxpayers. Thus, when considering what is more important, policymakers have to take current consequences, as well as future consequences, into account.

Problems with Persistent Negative Budget Balances

There are two main problems with persistent negative budget balances. First, when the government borrows, it crowds out private issuers who are looking to raise funds for investment projects to grow their businesses. The more government debt that is issued, the less demand there is for private debt or the higher interest rates private debt must offer in order to attract investors. Less demand for, or higher interest rates on, private debt leads to lower investment spending and a weaker economy.

Second, the government needs to pay interest on its debt, at a minimum. Failure to make interest payments on time is known as a default, which can have disastrous consequences for a nation's currency and economy. A default will lead investors to lose faith in the government's ability to pay its debt obligations, which leads to a decline in demand for government debt, thereby a decline in the price and an increase in the interest rate for that debt. It can also lead to a depreciation of the nation's currency as investors flee for safer pastures. This often leads to inflation. As you can imagine, an economy characterized by slowing investment, rising interest rates, and high inflation is not a desirable place to be.

To make matters worse, high debt levels and interest payments crowd out investing in other things the nation needs like infrastructure, education, healthcare, and defense. The standards of living for a nation can be severely curtailed with such heavy borrowing. If the nation prefers instead to keep its spending at current levels, it must then borrow even more to make up for what it had to pay in interest payments, and the vicious cycle continues. This is why it is so important to keep the future in mind when making decisions in the present. Today's mistake can be tomorrow's disaster.

Keeping High Debt Levels in Perspective

Even though a nation has very high debt levels, it must be kept in perspective. The way to do this is to compare the outstanding debt with the size of the economy.

Features of a Good Balanced Budget

The features of a good balanced budget would be tax revenue that is enough to cover government purchases of goods and services and transfer payments. The real problem lies in the fact that actual tax revenue is not known at the time when spending plans are laid out, so policymakers need to use estimated tax revenue in order to formulate their spending plans. Politicians generally favor a larger budget over a smaller budget, so spending plans tend to be larger than estimated tax revenue. While the amount of tax revenue collected depends on tax rates, the size of the tax base (number of tax-paying workers), and how fast the economy is growing, the amount the government spends depends on policymakers, their constituents, and their lobbyists. Because policymakers have both little control over and little knowledge of what the actual amount of tax revenues collected will be, there is little incentive to be conservative in their spending plans. At least in the United States, policymakers know that they can always borrow to make up the difference because United States debt is considered the safest in the world. Thus, at least in the United States, there will most likely never be a balanced budget rule, because, in the eyes of most politicians, it is simply not necessary.