Budget Deficit: Causes, Effects, and Prevention Strategies

What Is a Budget Deficit?

A budget deficit occurs when government expenses exceed revenue. Many people use it as an indicator of the financial health of a country. It is a term more commonly used to refer to government spending and receipts rather than businesses or individuals.

Budget deficits affect the national debt, the sum of annual budget deficits, and the cumulative total a country owes to creditors. 

Understanding Budget Deficits

When a budget deficit is identified, current expenses exceed the income received through standard operations. To correct its nation's budget deficit, often referred to as a fiscal deficit, a government may cut back on certain expenditures or increase revenue-generating activities.

A budget deficit can lead to higher levels of borrowing, higher interest payments, and low reinvestment, which will result in lower revenue during the following year.

The opposite of a budget deficit is a budget surplus. When a surplus occurs, revenue exceeds current expenses, resulting in excess funds that can be further allocated. When the inflows equal the outflows, the budget is considered balanced.

In the early 20th century, few industrialized countries had large fiscal deficits; however, during the First World War, deficits grew as governments borrowed heavily and depleted financial reserves to finance the war and their growth. These wartime and growth deficits continued until the 1960s and 1970s, when world economic growth rates dropped.

What Causes a Budget Deficit?

Both levels of taxation and spending affect a government's budget deficit. Common scenarios that create deficits by reducing revenue and increasing spending include:

• A tax structure that undertaxes high-wage earners but overtaxes low-wage earners.
• Increased spending on programs like Social Security, Medicare, or military spending.
• Increased government subsidies to targeted industries.
• Tax cuts that decrease revenue but provide corporations with funds to increase employment.
• Low GDP, or gross domestic product, results in lower tax revenue.

Budget deficits may occur as a way to respond to certain unanticipated events and policies, such as the increase in defense spending after the September 11 terrorist attacks.

Effects of a Budget Deficit

Budget deficits affect individuals, businesses, and the overall economy. As the government takes steps to improve the deficit, spending for programs such as Medicare or Social Security may be curtailed. Improvements to infrastructure may also be affected.

To increase revenue, tax hikes may occur for high-income earners or large corporations, which may affect their ability to invest in new business ventures or hire new employees.

Strategies Used to Reduce Budget Deficits

Countries counter budget deficits by promoting economic growth through fiscal policies, such as reducing government spending and increasing taxes. Determining the best strategies regarding which spending to cut or whose taxes to raise are often widely debated.

To pay for government programs while operating under a deficit, the federal government borrows money by selling U.S. Treasury bonds, bills, and other securities.

The Bottom Line

Budget deficits are a negative balance between a government's spending and revenues. When a government spends more than it collects in tax revenues, there is a deficit. Conversely, if there is more collected than spent, there is a surplus.