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Government Budget Deficits and Economic Growth

By Michael W. Klein·July 12
Fletcher School, Tufts University

The Issue:

The United States government budget deficit was $587 billion in 2016, representing 3.2 percent of that year’s Gross Domestic Product (GDP). The Congressional Budget Office (CBO) projects that the budget deficit will rise to 5 percent of GDP in 2027, even if the economy is operating near full capacity at that time, while other analysts project a rise to 6.1 percent of GDP in that year. In contrast, the Trump Administration's budget proposal has estimated that the U.S. will have no budget deficit in ten years but instead will be running a small budget surplus.
Why are the administration's and the CBO's budget deficit projections so different? And, why does it matter?

The Facts:

  • In any given year, the difference between federal tax receipts and federal spending, including spending on servicing the outstanding federal debt, determines whether the U.S. Government has a budget deficit or a budget surplus. Over the past 50 years, the U.S. federal government has run budget deficits every single year with the exception of five years — once in the late 1960s and during four years beginning in the late 1990s — such that the deficit averaged 2.8 percent of GDP between 1967 and 2016 (see the blue bars in the chart – negative values imply budget deficits).
  • The size of the federal budget deficit is tightly linked to how well the U.S. economy is performing. When the economy grows at a faster rate, this raises tax revenues and tends to lower spending on social safety net programs (since fewer people need these programs when the economy is doing well). Therefore, faster GDP growth reduces the budget deficit, even with no change in underlying economic policies. (The green line in the chart represents the GDP Gap, an indicator of the performance of the economy.) This works in reverse, too; during a recession, the budget deficit increases. These automatic stabilizers help to mitigate the impact of cyclical downturns, even with no change in spending or tax policy. In addition to this, governments may also use countercyclical policies, cutting tax rates and raising government spending during a recession in an effort to boost economic growth. For example, in response to the Great Recession that began in Autumn 2008, the most severe economic downturn in the United States since the Great Depression of the 1930s, the American Recovery and Reinvestment Act (ARRA) of 2009 included federal tax cuts, increases in spending on education, health care and infrastructure, and an expansion of social welfare programs, including unemployment benefits, that were worth $787 billion. Subsequently, the budget deficit averaged 8.1 percent of GDP between 2009 and 2012, reflecting both the Great Recession and the policy responses to that downturn. Starting around 2012, the government's budget deficit shrank to levels much closer to the 50-year average as the economy improved.
  • Because of the close link between economic growth and fiscal health, projections of the federal government's fiscal balance depend critically on projections of the economy’s  performance. Widely different forecasts of the economy's expected rate of growth underlie an important part of the differences in the budget deficit forecasts by the Trump administration (maroon bars in the chart), the CBO forecast (the orange bars in the chart) and other forecasts. The administration's view is based partly on the assumption that the United States can reach sustained growth rates of Gross Domestic Product (GDP) of 3 percent, as well as assumptions that proposed spending cuts and tax cuts are enacted. In contrast, the CBO projections are based on an assumed average economic growth rate of 1.8 percent in the years 2017 to 2021, and a growth rate of 1.9 percent in each subsequent year to 2027. Also, by statute, the CBO budget forecast must assume the maintenance of current laws. An alternative estimate that uses the CBO’s economic growth forecasts but has different assumptions about spending and tax cuts (a so-called current-policy assumption rather than the CBO’s current-law assumption) by Alan Auerbach and Bill Gale results in bigger budget deficits in each year after 2018, with the deficit rising to 6.1 percent in 2027.
  • Despite very recent strong job growth, an ongoing growth rate of 3 percent over a longer horizon is at odds with other forecasts and analyses of likely United States GDP growth. Higher rates of growth would lead to lower deficits, but there are reasons to think that the rates of growth will not be high enough to bring down the deficit-to-GDP ratio. The International Monetary Fund (IMF), in its annual Article IV report on the United States, notes that the country is in its third-longest expansion since 1850, but “the outlook is clouded by important medium-term imbalances” and that “even with an ideal constellation of pro-growth policies, the potential growth dividend is likely to be less than that projected in the budget and will take longer to materialize.” An  EconoFact analysis by Dan Sichel also shows that, because of trends in labor force growth and economic productivity, the economic growth projections of the Administration are very likely too rosy. Thus it is unlikely that high GDP growth will save the economy from rising government budget deficits.

What this Means:

Large government budget deficits may be warranted at times when the economy is in a downturn, like during the Great Recession that began in 2008, in order to stimulate spending and mitigate economic weakness. But large deficits that occur when the economy is at or near its full-capacity raise concerns of increasing costs of borrowing, reduced private capital formation, and potential financial and economic destabilization. Deficits can shrink with strong economic growth, but the combination of likely policies and plausible GDP growth rates for the United States point towards rising deficits over the next decade. The size of the difference between the Administration’s assumption about economic growth and that of the CBO is unprecedented, which has implications for the Administration’s claim that its policies will balance the budget by 2027.

Topics:

Economic Growth / Federal Budget Deficit / Fiscal Policy
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