In a recession, the government’s budget will go into cyclical deficit as tax revenue falls and government spending on unemployment and other benefits rises. Provided the deficit is purely cyclical, it can be seen as desirable since it acts as an automatic fiscal stabiliser, boosting aggregate demand and helping to pull the economy out of recession. Once the economy returns to potential national income (i.e. a zero output gap), the deficit would disappear. At potential national income (Yp), government expenditure (including benefits) will equal tax revenue. The budget is in balance.
Again, provided that the deficit is only cyclical, discretionary expansionary fiscal policy that further deepens the deficit will not be a problem for public finances in the future. Once the economy pulls out of recession, the discretionary policy can be relaxed and the higher national income will eliminate the cyclical deficit.
But the problem the Chancellor of the Exchequer faced in the Budget (on 22/4/09) was not just one of tackling the recession. The UK economy has seen a massive growth in the structural deficit. His forecast is for the total deficit to be £175bn in 2009. But, according to calculations by the Institute for Fiscal Studies, even when the recession is over and the output gap has been closed, there will still be an annual deficit of around £140bn. This is not cyclical; it’s structural.
So why is there this huge structural deficit? And what is the solution? Will the solution slow down recovery? The following articles look at the issues.
Budget 2009: Tightening the Squeeze? Institute for Fiscal Studies (23/4/09)
We should start by admitting we’ve failed as an economy: Hamish McRae Independent (22/4/09)
Budget 2009: Experts cast long shadow over Darling’s sunny outlook Guardian (23/4/09)
Budget 2009: Economist warns of spending cuts and tax rises Guardian (23/4/09)
The chancellor’s Budget dilemma: Stephanie Flanders BBC News (23/4/09)
For a global perspective on structural deficits, see:
Why the ‘green shoots’ of recovery could yet wither Financial Times (22/4/09)
Full details for the Budget can be found from the Treasury’s Budget site
- Explain the terms ‘cyclical deficit’ and ‘structural deficit’.
- Draw a diagram showing how government expenditure (including benefits) and tax revenue vary with national income. The diagram should show the sitation with no structural deficit: i.e. the two lines should cross at potential national income. Illustrate (a) a cyclical deficit where actual national income is below potential national income (a negative output gap) and (b) a cyclical surplus where actual national income is above potential income (a positive output gap).
- Now, on the same diagram, shift the two lines to illustrate a situation of structural deficit.
- Consider whether the government should attempt to increase or reduce the budget deficit at a time of recession.
- Why has the structural deficit become so severe over the past year?
- How quickly should the government set about tackling the structural deficit?