Definitions of government budget deficit

Government Budget – Key Concepts (Cambridge 0455)

1. Core Definitions (required by the syllabus)

• Government budget: The annual plan that shows the total amount of public expenditure (G) and the total amount of public revenue (T) that the government expects to raise in a fiscal year.
• Budget deficit: The situation in which total public expenditure exceeds total public revenue (G > T) in a given year.
• Budget surplus: The situation in which total public revenue exceeds total public expenditure (T > G) in a given year.
• Balanced budget: The situation in which total public expenditure equals total public revenue (G = T) in a given year.

2. The Budget Equation

The relationship between revenue and expenditure can be expressed as:

Budget balance = T – G

• If T – G > 0 → surplus
• If T – G = 0 → balanced budget
• If T – G < 0 → deficit

3. Numerical Illustrations

If the country’s GDP that year is £500 bn, the deficit as a percentage of GDP is:

\[

\frac{20}{500}\times 100 = 4\%

\]

Reasons for Government Spending (4.2.3)

• Allocation: To provide public goods and services that the market would under‑supply (e.g., roads, education, defence).
• Redistribution: To reduce income inequality through transfers such as pensions, unemployment benefits and welfare payments.
• Stabilisation: To smooth the business cycle – counter‑cyclical spending can support demand in a recession and be withdrawn in a boom.
• Economic growth: Investment in infrastructure, research and development that raises long‑run productive capacity.

Components of the Budget

Government Expenditure (G)

• Goods and services (e.g., roads, schools, health care)
• Public‑sector wages and salaries
• Interest payments on existing public debt
• Transfer payments (benefits, pensions, subsidies)

Government Revenue (T)

• Direct taxes – income tax, corporation tax
• Indirect taxes – VAT, excise duties, customs duties
• Non‑tax revenues – fees, royalties, dividends from state‑owned enterprises, sale of assets

Types of Budget Deficit

Separating Structural and Cyclical Deficits

1. Estimate the economy’s potential output (the level of GDP at full employment).
2. Calculate the output gap = Actual GDP – Potential GDP.
3. Adjust the observed deficit for the effect of the output gap; the residual is the structural deficit.

Fiscal Policy and the Budget Deficit

Fiscal‑policy tools

• Government spending (G): Increasing G widens the deficit; decreasing G narrows it.
• Taxation (T): Raising taxes increases T and reduces the deficit; cutting taxes does the opposite.

Link to the three macro‑economic aims

• Economic growth: Deficit‑financed spending can boost aggregate demand and raise output in the short run.
• Full employment: Public‑sector projects create jobs, reducing unemployment during a downturn.
• Price stability: Large, persistent deficits may overstimulate demand, creating inflationary pressure.

Interaction with other policies

• Monetary policy: Central banks may raise interest rates to counteract inflationary effects of a large deficit.
• Supply‑side measures: Improving productivity raises potential output, which reduces the cyclical component of the deficit.

Evaluation of Budget Deficits (AO3)

Advantages (short‑run)

• Provides fiscal stimulus during a recession, helping lift output and employment.
• Allows the government to maintain essential services when tax receipts fall.
• Finances long‑term investment (infrastructure, education) that can raise future growth potential.

Disadvantages (short‑ and long‑run)

• Increases public debt, leading to higher future interest payments.
• May raise borrowing costs for the private sector (crowding‑out) if government borrowing competes for funds.
• Risk of inflation if demand‑stimulating spending exceeds the economy’s productive capacity.
• Future generations may bear the burden of debt repayment.

Balanced view

Deficits are a useful counter‑cyclical tool when the economy is below potential, but they must be kept at sustainable levels. A moderate deficit in a downturn is generally acceptable, whereas a persistent large deficit can threaten fiscal sustainability and price stability.

Suggested Diagrams for Exam Answers

• Bar chart comparing G and T to illustrate deficit, surplus, and balanced‑budget cases.
• Budget‑line diagram (T on the horizontal axis, G on the vertical axis) with the 45° line; the area between the line and the 45° line shows the size of the deficit or surplus.
• AD–AS diagram showing a rightward shift of AD due to expansionary fiscal policy and its short‑run impact on output and price level.
• Graph separating primary deficit from total deficit (total = primary + interest payments).

Quick‑fire Review – Syllabus Alignment (Section 4.2)