How Does Fiscal Policy Impact the Budget Deficit?

Fiscal policy refers to the use of the government budget to affect the economy. This includes government spending and levied taxes. The policy is said to be expansionary when the government spends more on budget items such as infrastructure or when taxes are lowered. Such policies are typically used to boost productivity and the economy. Conversely, the policy is contractionary when government spending decreases or taxes rise. Contractionary policies might be used to combat rising inflation. Generally, expansionary policy leads to higher budget deficits, and contractionary policy reduces deficits.

Key Takeaways

  • Governments use fiscal policy such as government spending and levied taxes to stimulate economic change.
  • Expansionary policy is characterized by increased government spending or lower taxes to boost productivity.
  • Contractionary policy is characterized by decreased government spending or increased taxes to combat rising inflation.
  • Expansionary policy leads to higher budget deficits, and contractionary policy reduces deficits.

Keynesian Macroeconomics

The accounting for government budgets is similar to a personal or household 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 feasible for governments to spend more than they brought in. Governments could borrow money and increase spending as part of a targeted fiscal policy.

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

Expansionary Policy

Governments can spend beyond their tax-based budgetary constraints by borrowing money from the private sector. The U.S. government issues Treasury Bonds to raise funds, for example. To meet its future obligations as a debtor, the government must eventually increase tax receipts, cut spending, borrow additional funds or print more dollars.

Not all economists agree on the net effect of expansionary fiscal policy on the budget in the long run. In the short run, either surpluses will shrink, or deficits will grow.

Contractionary Policy

Contractionary policy is the opposite of expansionary policy. A $200 million tax cut is expansionary because it means that people will have more money to spend, which should boost demand for products and stimulate the economy. A $200 million tax increase is contractionary because people have less to spend, which reduces demand and slows the economy. Under contractionary policies, deficits will shrink, or surpluses will grow.

It is possible for a government to use both expansionary and contractionary policy tools at the same time. For example, the U.S. government might cut taxes and spending simultaneously. If the tax cuts are equal to $100 million in revenue and the spending cuts are only equal to $50 million, then the net effect is expansionary.

The United States Deficit

The U.S. federal budget deficit for the fiscal year 2020, which ended on September 30, was $3.13 trillion, according to the Congressional Budget Office (CBO). That was more than triple the deficit in fiscal 2019. According to the CBO in their year-to-end 2020 review, spending totaled $6.55 trillion while the estimated revenue was $3.42 trillion.

The deficit in the United States is the result of three factors. The War on Terror following 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 burgeoning deficit because they reduce revenue for each dollar cut. In 2013, The Center on Budget and Priority Policies estimated that the Bush tax cuts would add $5.6 trillion to the deficit from 2001 to 2018.

The Trump 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 that the cuts should stimulate growth by 0.7% annually offsetting some of the lost income, the deficit will increase $1 trillion over the next decade. Lastly, 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's Current Account Surplus

Germany had the largest surplus in 2019 at $293 billion, according to the IFO Institute. Japan has the next largest surplus at $200 billion (4% of its economic output) followed by The Netherlands at $110 billion (12% of its economic output).

Germany is benefitting from its trade with other euro countries, other EU countries, and the United States. Also, Germany has income from foreign assets 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 income, but current account surpluses can become problematic if receivables cannot be collected from other countries who may not be able to service their interest burden.

Article Sources
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  1. Congressional Budget Office (CBO). "Monthly Budget Review: Summary of Fiscal Year 2020," Page 1.

  2. Center on Budget Policy and Priorities. "The Legacy of the 2001 and 2003 "Bush" Tax Cuts."

  3. Committee for a Responsible Federal Budget. "Tax Cuts and Jobs Act Will Cost $1.5 Trillion."

  4. U.S. Congress. "H.R.1 - An Act to Provide Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018."

  5. Joint Committee on Taxation (JCT). "JCX-69-17 (December 22, 2017)," Download "Macroeconomic Analysis Of The Conference Agreement For H.R.1, Tax Cuts and Jobs Act," Page 1.

  6. Kaiser Family Foundation (KFF). "The Facts of Medicare Spending and Financing."

  7. IFO Institute. "Germany's Current Account Surplus Falls Slightly."

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