Definition of budget deficit: the shortfall between the income and expenditure of a person, organisation or government over a period of time.
What is the budget deficit?
The budget deficit refers to the official shortfall between the revenues of a government (through taxes and other) and the expenditures of a government in a year. You’ll see this phrase frequently in the best economics books.
In the UK, the slightly independent Office for Budget Responsibility (OBR) measures and reports on the budget deficit. For example, take a look at this article where they report that the UK budget deficit has reached £174bn after just 5 months of a financial year.
Why is the national budget deficit important?
The national budget deficit is an incredibly important figure for HM Treasury and the public as a whole. This is because of the direct link between the budget deficit and other important economic concepts:
Government income from taxes, less public spending equals the budget deficit, which must be funded by borrowing.
Indeed, the budget deficit is closely monitored because any budget deficit needs to be paid for. The deficit cannot be paid for with income, as by definition, all income has already been spent if a government is in deficit.
Therefore governments issue unsecured government bonds to the financial markets to raise more funds to pay for the deficit. This adds to the national debt, which stands at roughly £2 trillion in 2020.
A budget deficit isn’t necessarily a naughty word. Modest increases in the national debt can be harmless because the size of the economy also generally grows each year. If the national debt only sizes at the same pace as the wider economy, then the repayments on that debt remains equally affordable.
However, in times of tax reductions (recessions) or increases in public spending (times of crisis), the budget deficit can sharply increase, leading to unsustainable growth in the public debt.
If such increases remain unchecked, this can lead to the country defaulting on its debts, which causes
- Loss of business confidence
- Higher interest rates on future government borrowing
- Capital moving out of the country into safer jurisdictions
- A weakening of the foreign exchange rates relative to other currencies
How is the phrase budget deficit used in a sentence?
“The best business books warn that a government which increases the budget deficit, is inadvertently creating a more unfavourable business environment in the future, as taxes will need to rise eventually to close the gap.”
What else you should know about budget deficits
Most countries spend more than they tax, but not all countries operate with a budget deficit. Exceptions to the rule include:
- South Korea
- Hong Kong
This list shares many more.
These countries have a budget surplus, which means that the balance sheet of the government actually strengthens each year.
How does the definition of budget deficit relate to investing?
Generally, high budget deficits imply the the government is providing additional stimulus to an economy by boosting its spending beyond its natural level. This can lead to higher levels of trade and an increase in share prices.
However, when a nation’s debt becomes too high, it constrains the government by taking large stimulus off the table in the near future, and this can make investors nervous.
A government with limited remaining financial firepower can ill afford to bail out the industry on a large scale. This increases the risk of owning a business.