What determines the size of a fiscal deficit

Overview

Effect of a rise in unemployment on a fiscal deficit, inflation affect the size of a fiscal deficit and how one-off shocks affect a fiscal deficit.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why does the position of the economy in its cycle have such a strong influence on the deficit?

   Model answer

   Most tax revenue is levied on activity, so it moves with the economy: income tax and national insurance depend on employment and earnings, consumption taxes depend on spending, and corporation tax depends on profits, which are the most cyclical item of all. Meanwhile a large part of spending moves in the opposite direction, because unemployment and means-tested benefits are claimed by more people when the economy weakens. In a downturn revenue falls and spending rises simultaneously, so the deficit widens sharply without any decision being taken; in a boom the reverse happens. This is why a deficit can change by several percentage points of GDP purely as a consequence of the cycle.

2. 2

   Analyse the effect of a rise in unemployment on a fiscal deficit.

   Model answer

   It affects both sides of the account at once. Each person who loses a job stops paying income tax and employee contributions on their earnings, and the employer stops paying its contribution, so revenue falls; their spending also drops, so consumption tax receipts fall too. At the same time they become entitled to unemployment and often to housing and other means-tested support, so spending rises. Prolonged unemployment adds a further cost, because skills erode and some of those affected never return to work, which permanently lowers the tax base. The deficit therefore worsens by considerably more than the benefit payment alone.

3. 3

   Analyse why an ageing population tends to widen a fiscal deficit over time.

   Model answer

   An older population changes both the number of people paying tax and the number drawing on public spending. A smaller share of the population is of working age, so the base for income tax and contributions grows more slowly relative to the population. A larger share is retired, so spending on state pensions rises, and because the pension is usually uprated at least with earnings or prices, it grows automatically. Health spending rises disproportionately, since costs per person are far higher in the last years of life, and social care costs rise with the number of very old people. The pressure is structural rather than cyclical, meaning it does not reverse with recovery, and it builds gradually over decades, which is what makes it politically easy to postpone.

4. 4

   Analyse how interest rates and the existing stock of debt influence the size of a fiscal deficit.

   Model answer

   Debt interest is a component of government spending, so a country entering a period with a large debt stock must fund a large interest bill before it spends anything on services, and that bill is part of the deficit it reports. When market interest rates rise, the cost of issuing new debt and of refinancing maturing debt rises with them, so the bill grows year by year as old low-yield bonds are replaced. This creates a compounding risk: a large deficit builds a large debt, the large debt generates a large interest bill, and the interest bill enlarges the deficit again. How fast the effect arrives depends on the average maturity of the debt and on how much of it is index-linked or floating.

5. 5

   How does inflation affect the size of a fiscal deficit?

   Model answer

   The effects run in both directions and the net result depends on the details. Revenue tends to rise quickly, because consumption taxes are levied on prices, wages rise in nominal terms so income tax receipts grow, and if tax thresholds are not raised in line, people move into higher bands and the effective tax rate rises. Spending rises too, but often with a lag and only where it is indexed: benefits and pensions uprated to a past inflation figure catch up a year later, public sector pay is negotiated separately, and the cost of goods and services the state buys rises immediately. The interest bill rises sharply if debt is index-linked, since the principal is uprated with prices. In the short run inflation usually narrows the deficit because revenue responds faster than spending; over time the spending side catches up and the advantage fades.

6. 6

   In what ways do deliberate policy choices influence the deficit?

   Model answer

   The deficit is ultimately the arithmetic result of decisions about how much to spend and how much to raise. Governments choose the scope and generosity of public services, benefits and pensions, the rates and thresholds of taxes, the level of public investment, and whether to fund new commitments by taxing or by borrowing. Political pressures push in a systematic direction, since increases in spending and reductions in tax are both popular while the reverse is not, and the cost of borrowing appears only later and is diffuse. Election cycles can therefore produce loosening before a vote and tightening after one, and a commitment such as a new benefit or a pay settlement is far easier to introduce than to withdraw, so the structural position tends to drift unless it is deliberately controlled.

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