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A budget defecit
exists when the value of government spending exceeds its revenue per time period.
When government spending (G) exceeds tax revenue (T), that is, G > T
An example of a budget deficit is the COVID-19 pandemic, where governments across the world increased their level of spending in order to support households and business owing to the major economic recession.
Budget deficits leads to government or national debt
Government debt
the accumulated government budget deficits from previous years.
It represents the total amount of money owed by a government to its domestic and foreign creditors, such as commercial banks, the IMF and the World Bank
Why is a sustainable level of government debt important?
important for the effective operations of the economy over the long term, as no government can continually spend more than it collects from tax revenues
running a budget deficit can be beneficial in the short run as the government spending represents an injection into the circular flow of income, thereby stimulating economic growth and maintaining and/or creating jobs. However, budget deficits are not sustainable in the long run.
Measurements of government debt
main way to measure government debt is to express the national debt as a percentage of GDP. This shows the % of annual national income that the government owes to its creditors
The debt to GDP ratio expresses a country’s national debt as a % of its GDP (national income). The higher the debt to GDP ratio, the more unaffordable the debt
Relationship between a budget deficit and government debt
There is a direct relationship between a budget deficit and national debt because each time a government runs a budget deficit, it adds to the national debt.
Government debt needs to be managed carefully as debt interest means that national debt will simply grow exponentially if repayments are not made. Escalating debts may require the government to run further budget deficits.
Any time when the government can run a budget surplus (T > G), this surplus can be used to pay off some of the existing national deb
Example of a country with a high national debt to GDP ratio
Venezuela had a national debt to GDP ratio of 350% in 2021. This meant that for every $1m of GDP, the nation owed $3.5m. The government would need to pay off this debt over time, by reducing its spending and/or raising tax revenues.
Costs of government debt
Debt servicing costs
Credit ratings
The impacts on future taxation and government spending
Costs of government debt- Debt servicing costs
This refers to the costs of financing the national debt, that is, the loan repayment plus interest charges incurred on the loan.
Compound interest on outstanding government borrowing adds to the national debt, so this must be managed carefully. There is also a large opportunity cost to debt servicing.
Costs of government debt- Credit ratings
This measures a borrower’s ability to repay a loan. Borrowers with a higher credit rating (credit worthiness) are more likely to be approved for loans as they are in a better position to repay the funds.
Credit ratings are related to the borrower’s credit history and measured level of risk
Escalating government debts mean the country will have a lower credit rating which makes the nation less attractive to financial lenders
Costs of government debt- The impacts on future taxation and government spending
National debt that is not managed and repaid will continue to increase exponentially due to compound interest, making it even more difficult to pay off
The likely result of this is cutbacks in government spending in order to repay national debt
Essentially this entails austerity measures (the combination of reductions in government spending and increases in taxation)
