Fiscal Policy - Causes of a Budget Deficit | tutor2u Economics
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Fiscal Policy - Causes of a Budget Deficit

  • Levels: AS, A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Governments in many countries run persistent annual fiscal deficits. A budget deficit occurs when tax revenues are insufficient to fund government spending, meaning that the state must borrow money, usually in the form of government bonds.

Revision video: Key Causes of Cyclical and Structural Budget Deficits

Cyclical and structural budget deficits - revision video

Why do some many countries run large and often semi-permanent fiscal deficits? A number of reasons can be put forward, some of them short-term and others linked to structural, deeper fiscal issues facing one or more countries in particular.



source: tradingeconomics.com

Cyclical reasons

For many countries a rising budget deficit is the inevitable result of experiencing a recession or a sustained period of slow growth.

In a downturn, revenue flows fall from direct and indirect taxes whilst at the same time, the government is required to pay more out in welfare benefits such as the means-tested income support, unemployment benefits and other welfare handouts.

So part of a fiscal deficit may be the consequence of the automatic stabilisers at work. These are the tax and government spending changes that happen automatically at different stages of the business cycle. The governments of most developed countries are prepared to allow the automatic stabilisers to work through because, when their economy recovers, the cyclical component of a fiscal deficit will diminish, indeed in an economic boom, the government may run a budget surplus.

Keynesian Fiscal Deficits

A large (and rising) fiscal deficit might also be the deliberate effect of a government choosing to use expansionary fiscal policy to boost aggregate demand, output and employment at a time when private sector demand (C+I+X) is stagnant or falling. Keynesian economists have long favoured the use of targeted and timely fiscal stimuli such as labour-intensive public works and other infrastructure investment projects, designed at kick-starting an economy suffering from a chronic lack of demand and income.

There is an intense debate about the effectiveness of fiscal stimulus policies - at the heart of the controversy is the likely size of the fiscal multiplier effect arising (for example) from a rise in government spending, or a series of tax cuts.

Structural reasons

For some countries, fiscal deficits seem an almost permanent feature, rarely is the government able to find enough tax revenue to cover the annual spending budgets. What structural problems / issues might lead to persistent fiscal deficits?

  1. High levels of tax avoidance and tax evasion - the former is legal (e.g. people and businesses taking advantage of tax loop-holes, tax relief, choosing to pay declared taxes in low-tax countries etc) but the subject of fierce media and popular criticism. The deliberate evasion of tax is illegal - in some countries governments are less effective than they might be in countering shadow markets where no tax is paid or in tracking down agents who are not paying the tax that is due.
  2. High levels of income and wealth inequality - some economists argue that highly unequal societies also end up with a worsening fiscal position for the government. The uber-rich are liable for higher taxes in a progressive system (and top rate taxpayers in the UK clearly pay a high % of total revenues) but they also have an incentive to use all of the legal tax avoidance schemes open to them. At the bottom end of the labour market, if millions of people are in low-paid, insecure work, many will not earn enough to pay much in tax and even more may remain dependent on top-up welfare benefits, adding to the pressure on government spending.
  3. Demographic pressures - these can affect the fiscal position too, for example an ageing population will cause an increase in government spending on the state pension; a fast-growing population (perhaps boosted by net inward migration) will also put more pressure on the government to fund essential public and merit goods.
  4. Government inefficiency - if the state sector is relatively less efficient in supplying public services, then value for money will be lower and more will have to be spent in total to provide the cover that people need. Free market economists favour a smaller government sector with many activities out-sourced or privatised to the private sector to supply.
  5. High levels of government subsidy / financial support - over time, total government spending can rise because of the many competing demand placed upon politicians and the effects of lobbying by (often influential / powerful) pressure groups. In some countries, public spending is bloated by very generous systems of farm / food / energy subsidies that are politically hugely difficult to remove. The state might also get locked into providing financial support for loss-making businesses and industries such as airlines.

These reasons help to explain why many countries run a structural budget deficit. This means that the budget deficit will not disappear when the economy is on the upswing of their economic cycle.


source: tradingeconomics.com

Generally - countries whose governments depend heavily on the tax revenues from just a handful of key industries are at risk of seeing their budget position worsen very quickly when the revenues and profits from these sectors suffer. Consider the budget effects on the world's major oil producers from the recent collapse in the global price of crude oil.

In many lower-income developing countries, import tariffs are an important source of revenue. So a sudden and large contraction in world / regional trade can have a powerful effect causing a government to run into major fiscal problems. In many of these countries, total tax revenues are a small percentage share of GDP.

The Saudi Arabian government usually runs a large budget surplus - but this disappeared in 2010 the last time that oil prices plummeted. Will the same happen in 2015?

source: tradingeconomics.com

Norway is an example of a country that nearly always runs a budget surplus - sometimes as much as 10% of GDP!

source: tradingeconomics.com

You will sometimes read about a government's "primary budget deficit" - this means the budget deficit before interest payments on the national debt are added to the figure. For example, Greece is now running a primary surplus, but the size of her national debt (and associated interest payments) means that the overall fiscal balance remains in deficit

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