Economic Growth and the Budget Deficit - Chains of Reasoning

Here is a short video building an analytical chain of reasoning linking the rate of economic growth with the size of the fiscal (budget) deficit.

Analyse why a higher rate of economic growth for a country is likely to reduce a government's budget deficit.

• A budget deficit occurs when state spending exceeds tax revenues causing the government to borrow money through the issue of bonds.
• An increase in short term economic growth represents an expansion of real GDP which in theory will lead to higher per capita incomes and rising consumer spending.
• As a result, the revenues received from direct tax revenues such as income tax and indirect taxes such as VAT will grow.
• For example, as unemployment falls, there will be more people in work earning above £50,000 a year at which the marginal tax rate rises from 20% to 40%
• Thus, if more people are earning higher incomes, state spending on means-tested welfare support such as universal credit will also drop.
• Consequently, we expect a period of rapid economic growth to cut a fiscal deficit.

Context for exam application

In 2019, the UK government borrowed £57 billion which was 2.7% of GDP. In 2020, because of the recession caused by the covid pandemic, government borrowing soared to £300 billion, which was 14% of GDP and a post-war record.