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Policies to reduce a budget deficit

 Tejvan Pettinger  July 17, 2017 (https://www.economicshelp.org/blog/6011/economics/policies-to-reduce-
budget-deficit/)  economics (https://www.economicshelp.org/blog/category/economics/)

A look at different methods to reduce budget deficits. A budget deficit occurs when a
government spending is greater than tax revenues. This leads to an accumulation of public
sector debt. If the deficits are unsustainable, this can cause rising bond yields (higher interest
payments) and in the worse case, lead to a loss of confidence in the government. Though this is
quite rare for countries with their own currency (i.e. not in Euro)

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Policies to reduce a budget deficit | Economics Help Page 2 of 9

(https://www.economicshelp.org/wp-content/uploads/2016/01/uk-net-borrowing-percent-
gdp.png)

The obvious way to reduce a budget deficit is to increase tax rates and cut government
spending. However, the difficulty is that this fiscal tightening can cause lower economic growth –
which in turn can cause a higher cyclical deficit (government get less tax revenue in a recession).
The best way to reduce fiscal deficits depends on the situation a country is in.

Different policies to reduce a budget deficit.

1. Cut government spending

The government can cut its public spending to reduce its fiscal deficit. For example, in the 1990s,
Canada reduced its public spending quite significantly. They evaluated many different
departments and cut spending by up to 20% within four years across the board. This proved a
successful policy in reducing the budget deficit. During this period of spending cuts, the
Canadian economy continued to grow which also helped reduce the budget deficit. However,
during the spending cuts, the Canadian economy benefited from lower interest rates to boost
spending, higher exports to the US, and a weaker exchange rate. The strong economy made it
much easier to cut spending.

In the 1920s, the UK cut spending drastically, (known as the Geddes Axe) but, combined with the
gold standard (fixed exchange rate), this contributed to deflation and lower growth. Therefore, in
this period, the government was relatively unsuccessful in reducing the debt to GDP ratio.

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Policies to reduce a budget deficit | Economics Help Page 3 of 9

– see: UK economy in the 1920s (https://www.economicshelp.org/blog/5948/economics/uk-

economy-in-the-1920s/)

This graph shows that – despite two decades of austerity, and cuts to government spending –
the UK was unsuccessful in reducing historically high levels of debt.

In the Eurozone crisis, many European countries have cut government spending to try and
reduce their budget deficits. For example, Greece, Ireland and Spain have all cut spending.
However, these spending cuts have contributed to a decline in economic growth, leading to
lower tax revenues and rising debt to GDP. These spending cuts have been much less effective
in reducing the budget deficit because these countries can’t devalue (Euro is a fixed exchange
rate), they can’t pursue a loosening of monetary policy and the Eurozone is in recession.
Therefore, spending cuts have been less effective in reducing the deficit but also caused further
economic problems. See also: Eurozone austerity
(https://www.economicshelp.org/blog/5837/economics/fiscal-multiplier-and-european-
austerity/).

Other Evaluation of Cutting Government spending

It depends on the type of government spending you cut. If you cut pension spending (e.g. make
people work longer), then there may be an actual increase in productive capacity. If you cut
public sector investment, it will have a bigger adverse effect on aggregate demand and the
supply side of the economy. Therefore, the temptation is for the government to cut benefits and
pensions as this can reduce spending with less impact on economic growth – but it will be at the
cost of increased inequality in society.

2. Tax increases
Higher taxes increase revenue and help to reduce the budget deficit. Like spending cuts, they
could cause lower spending and lead to a fall in economic growth. Again it depends on the
timing of tax increases. In a recession, tax increases could cause a significant drop in spending.
During high growth, tax increases won’t harm spending as much. It also depends on the type of
tax you increase. Recently, France increased taxes on the rich to over 70% – however, some have
complained this is too high and creates disincentives to work in France. If high marginal tax rates
do reduce incentives to work, the tax revenue raised may be less than planned. See: French
economic austerity. (https://www.economicshelp.org/blog/5820/economics/french-economic-
austerity/)

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Policies to reduce a budget deficit | Economics Help Page 4 of 9

3. Economic growth
One of the best ways to reduce the budget deficit as a % of GDP is to promote economic growth.
If the economy grows, then the government will increase tax revenue, without raising taxes. With
economic growth, people pay more VAT, companies pay more corporation tax (tax on profits),
and workers pay more income tax. High economic growth, is the least painful way to reduce the
budget deficit because you don’t need to raise tax rates or cut spending. However, many
countries with fiscal deficit crisis are often stuck in recession. Countries in the Eurozone
currently find it difficult to grow because of the nature of European monetary policy and the
constraints of the Euro. Also, economic growth may not solve the underlying structural deficit
(which occurs even during high growth) This may still require spending cuts or tax rises.

UK Budget deficit

(https://www.economicshelp.org/wp-content/uploads/2013/09/net-borrowing-55-14.png)

This graph shows that during a period of high economic growth in the 1980s, the UK budget
deficit fell – despite tax cuts. In the recession of 1991, the budget deficit increased sharply. This
shows the cyclical nature of budget deficits and the importance of economic growth to reducing
a deficit.

Bailout
In some circumstances, countries can be eligible for a bailout from an international organisation,
such as the IMF. This means they can draw on temporary funds to help with temporary liquidity
shortages. The bailout may reassure investors and give the country more time for dealing with
the deficit. For example, in the 1970s, the UK applied for bailout funds from the IMF. A bailout
usually comes with strict instructions on reducing the deficit – this may be politically easier when
it is enforced from the outside. However, in the case of severely indebted countries, a bailout
may be insufficient to deal with the underlying level of debt. Also, bailout conditions can be
highly controversial.

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Default
Sometimes countries have got to the stage where they can’t manage their budget deficit.
Arguably Greece is very close. The government have tried spending cuts and tax increases, but
the budget deficit continues to be large. Also, the fiscal consolidation has caused an economic
depression. Therefore, they may be better off defaulting, leaving the Euro and starting
again. Should Greece leave the Euro?
(https://www.economicshelp.org/blog/2928/economics/should-greece-leave-the-euro/) In the
past countries, such as Argentina and Russia have defaulted. The problem with defaulting is that
it destroys the savings of investors, and will make it difficult to borrow again from capital
markets.

UK experience since 2010

A central plank of the Conservative policy since winning the 2010 election has been to reduce
the budget deficit. This has led to a mild form of austerity. Strict spending limits, with some
departments seeing a cut in spending.

UK government spending as a % of GDP has fallen significantly.

However, the budget deficit has fallen more slowly than expected this is because:

• Low rate of economic growth (caused by weak global growth and the impact of austerity)
• Growing demand for social security spending (e.g. rising house rents, leading to higher
spending on housing benefit)
• Growing expenditure on pensions (due to ageing population and triple lock guarantee)

Summary

To reduce fiscal deficits, the government is likely to use a combination of policies. A key factor is
the timing of deficit reduction plans. If the country is already in recession, it is much more
difficult to reduce the deficit because fiscal consolidation tends to worsen the economic
situation leading to lower tax revenues. In some cases, austerity can even be self-defeating.

The best way to reduce the budget deficit is to aim for positive economic growth, but in the long-
term evaluate government spending commitments and reduce spending to sustainable levels.

Related

• Is Austerity self-defeating? (https://www.economicshelp.org/blog/5268/economics/is-

austerity-self-defeating/)
• Will spending cuts bring economic growth?
(https://www.economicshelp.org/blog/5590/economics/will-cutting-government-spending-
bring-economic-growth/)

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3 thoughts on “Policies to reduce a budget deficit”

Pingback: Examining the options for increasing funding for the Royal Navy | Save The Royal
Navy (http://www.savetheroyalnavy.org/wordpress/examining-the-options-for-increasing-
funding-for-the-royal-navy)

North'n Loans says: January 23, 2013 at 9:22 am

(https://www.economicshelp.org/blog/6011/economics/policies-
to-reduce-budget-deficit/#comment-76186)

The Minister of Finance is navigating troubled waters, not of his making. I would rather have
him push back the date for a balanced budget than continue to cut his way to one. Mulcair,
continues to think that you can blow and suck at the same time. You can’t increase spending
and balance a budget simultaneously Tommy. Fortunately he will never get his hands on the
levers of Power.

Reply (https://www.economicshelp.org/blog/6011/economics/policies-to-reduce-budget-
deficit/?replytocom=76186#respond)

omar (http://NONE) says: March 13, 2018 at 9:22 am

(https://www.economicshelp.org/blog/6011/economics/policies-
to-reduce-budget-deficit/#comment-349517)

In the humble opinion, I advise countries to increase the tax rate, reduce the interest rate
on loans and increase the salaries of workers to reduce the rate of stagnation and economic
stagnation in order to spin the economy and help economic growth to increase.
Please reply to my analysis
I am an economic analyst and a development expert and a trainer in the preparation of
budgets.

Reply (https://www.economicshelp.org/blog/6011/economics/policies-to-reduce-budget-
deficit/?replytocom=349517#respond)

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