The term budget deficit refers to a situation when government spending is greater than the tax revenues generated during a fiscal period. budget deficit is common among contemporary governments across the globe.
The scope government activities vary with country to country as richer economies do more such activities than the poorer economies. Since the end of World War-II, prime areas of concern of various governments are ensuring economic security for the citizens in the form of welfare state, unemployment insurance, pensions, social security, public goods such as education and health etc. The cost of government activities is met out of revenues which is mainly raised from taxation. No matter the size of the government activities, spending is always higher than the tax revenues in almost all the countries.
The best way to reduce a budget deficit is to increase in tax rates and cut government spending. However, such fiscal tightening may lead to lower economic growth which in turn can cause a higher cyclical deficit as government get less tax revenue in recession. The government needs to use a combination of policies to reduce budget deficit. Timing is a key factor while deciding on such policy measures. If the country is already in recession, it is much more difficult to reduce the deficit because fiscal consolidation may worsen the economy and lead to lower collection of tax revenues.
Considering the above facts, some of the policy measures that the government may decide to cut down budget deficit, depending on the situations, are placed below.
- Cut in government spending
The government can cut its public spending to reduce its budget deficit. This policy proves to be successful in reducing the budget deficit if the economy continues to grow with situations like lower interest rate, favourable conditions for export etc. The strong economy makes it easier to cut spending.
It depends on the type of government spending also. Cut in pension spending would make people work more longer and increase in productive capacity. However, cut in public sector investment may lead to bigger adverse effect on aggregate demand and the supply side of the economy.
- Increase in Tax Revenue
Higher taxes increase revenue and would help to reduce the budget deficit. However, like spending cuts, such measures may cause lower spending and lead to a fall in economic growth. Again, it depends on the timing of tax increases. During recession, increase in tax rate could cause a significant drop in spending, but during high growth, tax increases won’t harm spending as much.
- Economic growth
The best way to reduce the budget deficit is to promote economic growth. If the economy grows, tax revenue will increase, without raising taxes. High economic growth is the least painful way to reduce the budget deficit because government need not to raise tax rates or cut spending.
- Bailout Method
Bailout from an international organisation, such as the IMF may also be raised to cut budget deficit. Such bailout may be useful in dealing with temporary liquidity shortages. The bailout may reassure confidence in investors and give the country more time for dealing with the deficit. However, bailout usually comes with strict instructions on reducing the deficit.
If government decides to reduce the deficit immediately, reducing spending alone would probably be damaging for the economy to recover from the situation. Likewise, raising taxes would raise unemployment. Higher tax rates reduce the incentives for work and discourages investment. Such situation can have supply-side effects and it may lower economic growth. Moreover, raising tax rates may result in under reporting of income and lead to decline in tax revenue.
Certain cuts in public spending may also have small effects on long-run growth. Cut in existing spending on social security and other welfare schemes could reduce the nation’s productivity. Therefore, such changes should be made in such a way which would protect the interest of the vulnerable section in the society. Government spending on scientific research, education and infrastructure, helps increase in future productivity. Such spending often produces high social returns. Cutting government spending in such sectors could have significant long-term effects on growth.
Both tax rate increase and spending cuts will tend to slow the recovery of the economy. However, spending cuts is likely slow it more. On long run, progressive and sensible tax rate increase will probably cause less damage to economic growth than cuts in government spending. Cut in public spending reduces GDP more, than an increase in tax rate would reduce it.
In view of above, plan for reducing the deficit should combine both spending cuts and tax rate increase. The cuts should spare valuable investment spending. On the other hand, the best way to raise revenue would be to limit tax breaks for individuals and corporations with a progressive tax policy.