How Budget Deficit Affects Economic Growth?

From 1975 to 1997 the federal government of Canada ran very large budget deficits, resulted a rapidly growing federal government debt. Over the last 20 years there has been a fierce debate over how the federal and provincial budget deficit affected long-term growth.

Imagine the government starts with a budget balance. If it runs a deficit, it will finance its debt through privatization or borrowing from its citizens (assuming a closed economy) In return the total savings, which is the funds available for investors to build new factory, or for households to buy a brand new home decreases. In conclusion the supply of available funds for investment decreases. That will result an increase in interest rates because of scarcity of available funds. This higher interest rate then alters the behavior of firms that participate in the loan market. Many demanders of loanable funds are discouraged by the higher interest rate. Fewer families buy new homes and fewer firms choose to build new factories. The fall in the investment because of government borrowing is called crowding out.

The result is when the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Canada experienced such a situation in between 1975 and 1997. During this period the budget deficit pushed the economy into a vicious cycle, where deficits cause lower economic growth that in turn lead to lower tax revenue and higher spending on Employment Insurance and other income-support programs. Lower tax revenue and higher government spending led the economic growth even lower levels which caused even lower tax revenues. Only way to break this vicious cycle was increasing tax rates and cutting government spending. However those tools cause even higher deficits and slower economic growth. That’s why it’s called vicious cycle.

On the other hand budget surpluses work just the opposite way of budget deficits. When government collects more in tax revenue than it spends, it saves the difference by retiring some of the outstanding government debt. This budget surplus or public saving contributes to national saving. Thus a budget surplus increases the supply of loanable funds reduces the interest rate and stimulates the investment. Higher investment in turn means greater capital accumulation and more rapid economic growth. In the era of high economic growth, government will collect more tax at the same tax rate. This is called virtuous cycle, but the next question is, Should government cut tax rates, increase spending on social programs, or pay down accumulated debt? This is a topic for another post.