See Business Cycle
Budget surpluses or deficits have been treated as inconsequential in themselves, to this point, having importance only to the extent that they affect Aggregate Spending. After decades of successively higher record federal deficits, a proposed constitutional amendment that the federal budget be balanced annually receives lots of popular support, but some serious pitfalls may be embedded in this appealing notion. Imbalance in the federal budget may be more a symptom of economic distress than a result of discretionary policy. For example, deficits swell during recessions because tax revenues fall and government outlays rise. Conversely, automatic stabilizers theoretically could create budgetary surpluses if unsustainable and inflationary growth mushroomed.
Should taxes be raised and government spending cut during a recession to eliminate a deficit? The preceding analysis suggests not. If inflation looms, should we cut taxes or raise spending to eliminate a surplus? Again, Keynesians conclude that this would be unwise. Federal deficits or surpluses are affected by the level of GDP as well as by discretionary fiscal policy, so the appropriateness of fiscal policy is not obvious solely from the evidence of actual deficits or surpluses. Economists now differentiate between structural and cyclical deficits.
A structural deficit (or surplus) is an estimate of the budget deficit (or surplus) that tax and spending structures would yield if the economy achieved its potential.
During a recession, estimating the structural deficit entails adding to the actual deficit extra tax revenues that would be collected if full employment were achieved and deducting the outlays on unemployment benefits and other transfer payments caused by cyclical unemployment.
A cyclical deficit occurs when falling income during a recession shrinks tax revenues while increasing transfer payments. Prosperity, on the other hand, could yield a cyclical surplus.
Whenever the economy deteriorates, the cyclical budget deficit worsens and vice versa.
Transfer payments can be treated as negative taxes (negative because the government pays people), which decline in importance as National Income rises. Figure 5 illustrates various possible relationships between net taxes (tax revenues minus transfer payments) and government purchases for three alternative tax structures. Note that the tax functions are all positively sloped; net taxes rise as income rises. We will assume that noninflationary full employment income is $7.5 trillion and that government purchases (G) are independent of income.
FIGURE 5 The Structural Deficit and the Cyclical Deficit
The structural deficit is the deficit that would exist at a full employment, given the existing mix of government spending and tax rate structures. The cyclical deficit grows when economic circumstances prevent full employment. This figure illustrates the relationship between net taxes (taxes minus transfer payments) and government spending for three alternative tax structures.
Tax structure T0 is associated with Aggregate Expenditures AE0, and a structural surplus of $100 billion prevents full employment, but at the equilibrium income of $7 trillion, the spending/tax structure yields a $50 billion cyclical deficit. Budget–tax combinations T2 and G are associated with Aggregate Spending of AE2 and represent a considerably more expansionary budgetary mix. At full employment, this budget–tax mix would result in a structural deficit of $100 billion. Tax schedule T1 is associated with Aggregate Expenditures AE1 and balances the budget at full employment ($7.5 trillion).
Note: Subscripts link tax structures (T) from Panel B with the resulting Aggregate Expenditure function (AE) in Panel A.
Excessive tax rates may limit Aggregate Spending to levels inadequate for full employment. This "fiscal-drag" case occurs with tax structure T0 and Aggregate Expenditure AE0, which together yield equilibrium at point a in Panel A of Figure 5. Tax rates are high, so the structural deficit at full employment (point b) is really a surplus to the tune of $100 billion in this example; however, the cyclical deficit at the $7 trillion equilibrium income (point a) is $50 billion. Thus, an excessive "structural surplus" can create a cyclical deficit.
Contrast this with the budgetary mix of G and tax structure T2. Simultaneous inflationary pressures and cyclical budgetary surpluses coexist if Aggregate Spending is AE2 and the tax schedule is T2; at equilibrium point c, a cyclical surplus of $50 billion is realized. This budget combination yields a structural deficit of $100 billion at full employment (ignoring inflationary pressure). This structural deficit is much more expansionary than that represented by G and T0. Finally, a combination that balances the structural budget is represented by tax schedule T1, which yields Aggregate Expenditure AE1. Cyclical deficits result below full employment, while surpluses are generated above full employment.
Suppose low tax rates bloat Aggregate Spending. A substantial cyclical budget surplus exists if the Aggregate Expenditure curve is AE2 and the tax curve is T2. If perpetually balanced budgets were legally mandated, we would cut taxes and raise spending—bad policies certain to worsen inflationary pressure. Policies of either raising tax rates or cutting spending may cure inflation by enlarging any current budget surplus to dampen Aggregate Spending.
During inflation, however, proposals that "government costs, in addition to other prices, need to be raised," are anathema to voters. But beneficiaries of public programs, including those whose incomes depend on government contracts, lobby against budget cuts that threaten their standards of living. Even politicians who constantly attack "big government" fear a backlash from voters whose pet programs are cut. In fact, political opposition to spending cuts or tax hikes is so intense that we need not worry about simultaneous inflation and actual surpluses.
The reverse situation is a budget structure with a structural surplus but a cyclical deficit because tax rates are so high that the economy is stuck well below full employment; fiscal drag is quite powerful. Some analysts have suggested that the sluggish American economy of the late 1950s and of the early 1980s suffered from this malady.
The critical point is that huge cyclical deficits do not imply an expansionary tilt to fiscal policy, nor are large cyclical surpluses evidence of contractionary policies. Mounting federal deficits in recent years have been a mix of (a) cyclical deficits driven by high unemployment that subsided only slowly after peaking during the recessions of 1981–1983 and 1990-1991, and (b) huge structural deficits, sparked in part by large tax cuts and by unrelenting growth of government outlays. Recent estimates place the structural deficit at nearly two-thirds of the actual deficit and growing.
In summary, the actual deficit is determined by the fiscal mix of the federal budget and the state of the economy. Expansionary fiscal policy creates structural deficits, and recession triggers cyclical deficits. Deficits may arise because high tax rates produce an anemic economy. Congress can only set tax rates; it cannot dictate the resulting tax revenues.