Fiscal Policy: Spending, Taxing and the Deficit

When a government spends more on goods, services, and payments to people than it collects in taxes over one year, the gap is called a budget deficit. To cover the gap, the government borrows money. All the borrowing piled up over many years is the national debt. A deficit is like water flowing into a bathtub during one year, while the debt is all the water sitting in the tub. That is why a single year's budget can change the deficit, but the debt keeps growing as long as deficits keep happening. Expansionary fiscal policy, like cutting taxes or raising spending during a recession, often means running a deficit on purpose to help the economy heal.

Spending your way out of a recession sounds simple, but there is a catch. When a government runs a deficit, it usually pays for it by borrowing money. That means the government is competing with families and businesses that also want to borrow from the same limited pool of savings. This competition can push interest rates up. When loans get more expensive, businesses may delay building factories or buying equipment, so private spending shrinks just as government spending grows. Economists call this crowding out. It is one reason some people argue that heavy borrowing today can become a burden on the economy tomorrow.

Governments influence economic activity through taxes and spending: fiscal policy. During a recession with job losses, expansionary policy increases spending or reduces taxes. Households and firms then have more money to spend, which can raise total demand. Contractionary policy reverses those choices. Spending cuts or tax increases can reduce demand when activity is too strong and inflation is too high. The suitable response depends on the economy's stage in the business cycle; neither approach suits every situation.

A budget records a government's priorities. In the United States, federal revenue comes mostly from taxes and funds services, benefits and defence. Congress and the president decide taxes and spending, using these choices to support the economy. Some theories favour extra government spending during downturns. Others favour tax cuts and a smaller government to encourage growth. Monetary policy is separate: the Federal Reserve manages money and interest rates, rather than the government's budget.

Compare a government's yearly spending with its revenue, including taxes. More spending than revenue creates a budget deficit. More revenue than spending creates a surplus. Equal totals mean a balanced budget.

Automatic stabilizers are existing tax and spending rules that respond without another law. During a slowdown, people pay less tax and receive more support payments. These changes cushion the fall in demand. As economic activity picks up, tax payments rise and support payments fall, helping to slow the expansion.