How Does Fiscal Policy Impact the Budget Deficit?

Fiscal policy refers to the use of the state budget to influence the economy. This includes government spending and taxes levied. The policy is said to be expansionary when the government spends more on budget items such as infrastructure or when taxes are lowered. These policies are generally used to boost productivity and the economy. Conversely, the policy is contractionary when government spending falls or taxes rise. Contraction policies could be used to fight rising inflation. Generally, expansionary policy leads to higher budget deficits, and restrictive policy reduces deficits.

Key points to remember

  • Governments use fiscal policy such as public spending and taxes levied to stimulate economic change.
  • Expansionary policy is characterized by increasing government spending or lowering taxes to boost productivity.
  • The policy of contraction is characterized by a reduction in public expenditure or an increase in taxes to combat rising inflation.
  • An expansionary policy leads to higher budget deficits, and a restrictive policy reduces deficits.

Keynesian macroeconomics

The accounting of government budgets is similar to a personal or family budget. A government runs a surplus when it spends less money than it earns through taxes, and it runs a deficit when it spends more than it receives in taxes.

Until the early 20th century, most economists and government advisers favored balanced budgets or budget surpluses. The Keynesian revolution and the rise of demand-driven macroeconomics made it politically possible for governments to spend more than they brought in. Governments could borrow money and increase spending as part of targeted fiscal policy.

An expansionary fiscal policy leads to higher budget deficits while a restrictive policy reduces deficits.

Expansionist policy

Governments can spend beyond their fiscal budget constraints by borrowing money from the private sector. The US government issues Treasury bills to raise funds, for example. To meet its future obligations as a debtor, the government may need to increase tax revenue, reduce spending, borrow additional funds, or print more dollars.

Not all economists agree on the net effect of expansionary fiscal policy on the budget long term. In the short termeither the surpluses will decrease or the deficits will increase.

Contractual Policy

The policy of contraction is the opposite of the policy of expansion. A $200 million tax cut is expansionary because it means people will have more money to spend, which should stimulate demand for products and stimulate the economy. A $200 million tax hike is restrictive because people have less to spend, which reduces demand and slows the economy. Under restrictive policies, deficits will decrease or surpluses will increase.

It is possible for a government to use both expansionary and restrictive policy tools. For example, the US government could reduce taxes and spending simultaneously. If the tax cuts equal $100 million in revenue and the expenditure cuts only equal $50 million, then the net effect is expansionary.

The US deficit

The US federal budget deficit for fiscal year 2020, which ended September 30, was $3.13 trillion, according to the Congressional Budget Office (CBO). This was more than triple the deficit in fiscal year 2019. According to the CBO in its 2020 year-end review, expenditures totaled $6.55 trillion while estimated revenues were $3.42 trillion.

The deficit in the United States is the result of three factors. The war on terrorism that followed the events of 9/11 has added $2.4 trillion to the debt since 2001. Annual military spending has doubled. Tax cuts are another cause of the growing deficit because they reduce revenue for every dollar cut. In 2013, the Center on Budget and Priority Policies estimated that Bush’s tax cuts would add $5.6 trillion to the deficit from 2001 to 2018.

The Trump’s tax cuts will also reduce revenue and increase the deficit; tax cuts total $1.5 trillion over the next 10 years. While the Joint Committee on Taxation expects the cuts to boost growth by 0.7% a year, offsetting some lost revenue, the deficit will rise by $1 trillion over the next decade. Finally, Social Security is another contributor to the deficit. According to the Henry J. Kaiser Family Foundation, Medicare spending accounted for 15% of total federal spending in 2017 and is expected to reach 18% by 2029.

Germany current account surplus

Germany recorded the biggest surplus in 2019 with $293 billion, according to the IFO institute. Japan has the second largest surplus with $200 billion (4% of its economic output), followed by the Netherlands with $110 billion (12% of its economic output).

Germany benefits from its trade with other eurozone countries, other EU countries and the United States. In addition, Germany has foreign asset income of around 63 billion euros.

Current account surpluses are associated with high net capital exports, and Germany has more financial claims on foreign countries than foreign countries have on Germany. Exports to foreign countries bring in income, but current account surpluses can become problematic if receivables cannot be collected from other countries that may not be able to pay their interest burden.

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