To the observer, welcome to session five of unit three. As previously stated, the majority of government expenditures are funded by tax revenue. However, when total expenditures exceed tax revenue, the government, like any other business or household, will borrow to cover the difference. We will now discuss this aspect of public finance. Government borrowing plays a significant role in the operation of fiscal policy discretion.

Objectives At the conclusion of this session, participants will be able to:

  • appreciate the important role of government borrowing in demand management
  • understand the relationship between government borrowing and the national debt
  • explain budget deficit or surplus

Now read on …


5.1 Government Borrowing

The annual budget represents the fiscal strategy or fiscal posture of the government.

For instance, the fiscal posture during a deflationary gap may be deficit financing, in which the government plans for a budget deficit to stimulate the economy.

Through the multiplier effect, this will result in an increase in aggregate demand, leading to greater income and employment, and possibly higher pricing.

In contrast, the government could plan for a budget surplus or for tax revenues to exceed government spending if the economy is overheating (i.e., an inflationary gap is emerging along with a larger penetration of imports into the economy).

Thus, the budget is a significant policy instrument available to a government for achieving specific economic objectives.

5.2 The Government’s Budget Deficit or Surplus

5.2.1 Budget Deficit

Budget deficit refers to the quantity of money borrowed by the government sector during a given fiscal year when expenditures exceed tax revenues. The magnitude of the budget deficit can be affected by a number of variables, including:

  1. the size of the budget deficit of central, and local governments;
  2. the size of the deficit of state industries and other state-owned corporations financed by borrowing from non-government sources;
  3. the amount of net lending by the government to the private sector and overseas;
  4. the government sector’s receipts from the sale of financial assets and other financial transactions;
  5. the government sector’s receipts from the sale of real assets (e.g. the proceeds from privatization).

5.2.2 Budget Surplus

A budget surplus exists when total tax revenues exceed total government sector expenditures.

A budget surplus indicates that the government is able to repay a portion of its accumulated debt from prior years.

The sum of government borrowings over time constitutes the national debt (also known as the aggregate public debt). A budget deficit increases the national debt, whereas a surplus decreases it.

If governments consistently operated with budget deficits, the national debt would continue to increase.

This debt would have to be financed by government borrowing, resulting in a rise in the proportion of annual government expenditure devoted to interest payments.

The result could be a pernicious cycle in which budget deficits grow due to the need to pay more interest on the national debt each year. In addition, the debt would need to be serviced as repayment and interest payments on government borrowing became due.

Servicing the national debt entails refinancing the national debt and paying the interest on the outstanding debt. Therefore, persistent budget deficits are imprudent and should not be required.

5.3 Cyclical Deficits and Structural Deficits

Cyclical deficits are budget deficits caused by the business cycle, which impacts the levels of tax revenues and government spending.

They are eliminated once the economy recovers. In contrast, budget deficits that persist throughout an entire economic cycle are referred to as structural deficits.

A cyclical deficit may be tolerated by the government, but a structural deficit is much more worrisome.

It denotes a long-term imbalance between government expenditure and tax revenue, resulting in an ever-increasing national debt.

If, as a result, the national debt rose faster than GDP, the ‘burden of the national debt’ would increase on the economy.

This burden is the cost of debt service. In this context, it should be noted that inflation decreases the real value of the national debt, as it does with other debts in the economy.

Therefore, concerns about the debt burden can increase during periods of low inflation or if prices in an economy truly fall (deflation).

Budgetary prudence necessitates the avoidance of structural deficits. Therefore, government long-term financing should only be used to fund capital investments and not current expenditures.

5.4 The Balanced Budget Multiplier

A balanced budget occurs when the sums of government expenditure (G) and taxation (T) are equal in any given fiscal year.

It is essential to recognize that a balanced budget is distinct from a neutral budget. A neutral budget stance occurs when budgetary policy has no effect on the level of aggregate demand in the economy and, consequently, economic activity.

At first inspection, it may appear that comparable expenditure and tax changes in the context of a balanced budget would have no impact on aggregate demand and, consequently, on national income, as the government spending change is completely offset by the tax change. However, this is false.

In general, accounting for savings, taxation, and imports, a balanced budget will have an expansionary effect on the national income, as demonstrated by this instance. The balanced budget multiplier reflects the impact of expenditures on imports, another leakage from the circular flow of income, in the same manner as savings.

In this session, we have examined in depth the essence of government borrowing. We also discussed budget deficits and surpluses, as well as the relationship between government borrowing and national debt.

The session concluded with a distinction between cyclical and structural deficits as well as an explanation of the balanced budget multiplier.

Self-Assessment Questions

Exercise 3.5

  1. Under what circumstance will there be a budget deficit or surplus
  2. What factors determine the size of a budget deficit?
  3. What is meant by national debt?
  4. What is a budget surplus?
  5. Explain what a balanced budget is. 6. Differentiate between cyclical deficits and structural deficits.




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