Headlines about the government’s budget tend to focus on just one point: whether the government is running a surplus or a deficit and, in either case, how big. People usually think of surpluses as good: when the federal government ran a record surplus in 2000, many people regarded it as a cause for celebration. Conversely, people usually think of deficits as bad: when the Canadian government ran a record deficit in 2010, many people regarded it as a cause for concern.

How do surpluses and deficits fit into the analysis of fiscal policy? Are deficits ever a good thing and surpluses a bad thing? To answer those questions, let’s look at the causes and consequences of surpluses and deficits.

What do we mean by surpluses and deficits? The budget balance, which we defined in Chapter 10, is the difference between the government’s revenue, in the form of tax revenue, and its spending, both on goods and services and on government transfers, in a given year. That is, the budget balance—savings by government—is defined by Equation 13-2 (which is the same as Equation 10-7):

where T is the value of tax revenues, G is government purchases of goods and services, and TR is the value of government transfers. As we learned in Chapter 10, a budget surplus is a positive budget balance and a budget deficit is a negative budget balance.

Other things equal, expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year. That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger. Conversely, contractionary fiscal policies—reduced government purchases of goods and services, lower government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

You might think this means that changes in the budget balance can be used to measure fiscal policy. In fact, economists often do just that: they use changes in the budget balance as a “quick-and-dirty” way to assess whether current fiscal policy is expansionary or contractionary. But they always keep in mind two reasons this quick-and-dirty approach is sometimes misleading:

To understand the second point, we need to examine the effects of the business cycle on the budget.

Historically there has been a strong relationship between the federal government’s budget balance and the business cycle. The budget tends to move into deficit when the economy experiences a recession, but deficits tend to get smaller or even turn into surpluses when the economy is expanding. Figure 13-7 shows the federal budget deficit as a percentage of GDP from 1975 to 2012. Shaded areas indicate major recessions. As you can see, the federal budget deficit increased around the time of each recession and usually declined during expansions. In fact, owing to economic expansions in the mid-1990s and early 2000s, the deficit actually became negative between the 1997–1998 fiscal year and the 2007–2008 fiscal year: the budget deficit turned into a budget surplus.

The relationship between the business cycle and the budget balance is even clearer if we compare the budget deficit as a percentage of GDP with the unemployment rate, as we do in Figure 13-8. The budget deficit almost always rises when the unemployment rate rises and falls when the unemployment rate falls.

Is this relationship between the business cycle and the budget balance evidence that policy-makers engage in discretionary fiscal policy, using expansionary fiscal policy during recessions and contractionary fiscal policy during expansions? Not necessarily. To a large extent the relationship in Figure 13-8 reflects automatic stabilizers at work. As we learned in the discussion of automatic stabilizers, government tax revenue tends to rise and some government transfers, like employment insurance benefits and welfare payments, tend to fall when the economy expands. Conversely, government tax revenue tends to fall and some government transfers tend to rise when the economy contracts. So the budget tends to move toward surplus during expansions and toward deficit during recessions even without any deliberate action on the part of policy-makers.

In assessing government budget policy (i.e., fiscal policy) it’s often useful to separate movements in the budget balance due to the business cycle from movements due to discretionary fiscal policy changes. The former are affected by automatic stabilizers and the latter by deliberate changes in government purchases, government transfers, or taxes. It’s important to realize that business-cycle effects on the budget balance are temporary: both recessionary gaps (in which real GDP is below potential output) and inflationary gaps (in which real GDP is above potential output) tend to be eliminated in the long run. Removing their effects on the budget balance sheds light on whether the government’s taxing and spending policies are sustainable in the long run. In other words, do the government’s tax policies yield enough revenue to fund its spending in the long run? As we’ll learn shortly, this is a fundamentally more important question than whether the government runs a budget surplus or deficit in the current year.

To separate the effect of the business cycle from the effects of other factors, many governments produce an estimate of what the budget balance would be if there were neither a recessionary nor an inflationary gap. The cyclically adjusted budget balance is an estimate of what the budget balance would be if real GDP were exactly equal to potential output. It takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated—or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated.

Figure 13-9 shows the actual budget deficit and the Parliamentary Budget Office estimate of the cyclically adjusted budget deficit, both as a percentage of GDP, from 1975 to 2012. As you can see, the cyclically adjusted budget deficit doesn’t fluctuate as much as the actual budget deficit. In particular, large actual deficits, such as those of 1984, 1992, and 2009, are usually caused in part by a depressed economy.

As we’ll see in the next section, persistent budget deficits can cause problems for both the government and the economy. Yet politicians are always tempted to run deficits because this allows them to cater to voters by cutting taxes without cutting spending or by increasing spending without increasing taxes. As a result, there are occasional attempts by policy-makers to force fiscal discipline by introducing legislation—even a constitutional amendment—forbidding the government from running budget deficits. This is usually stated as a requirement that the budget be “balanced”—that revenues at least equal spending each fiscal year. Would it be a good idea to require a balanced budget annually?

Most economists don’t think so. They believe that the government should only balance its budget on average—that it should be allowed to run deficits in bad years, offset by surpluses in good years. They don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers. As we learned earlier in this chapter, the tendency of tax revenue to fall and transfers to rise when the economy contracts helps to limit the size of recessions. But falling tax revenue and rising transfer payments generated by a downturn in the economy push the budget toward deficit. If constrained by a balanced-budget rule, the government would have to respond to this deficit with contractionary fiscal policies that would tend to deepen a recession.

Yet policy-makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary. As the following Economics in Action explains, Europe has had a lot of trouble reconciling rules to enforce fiscal responsibility with the challenges of short-run fiscal policy.

So the agreement reached in December 2011 was framed in terms of the “structural” budget balance, more or less corresponding to the cyclically adjusted budget balance as defined in the text. According to the new rule, the structural budget balance of each country should be very nearly zero, with deficits not to exceed 0.5% of GDP. This seemed like a much better rule than the old stability pact.

Yet big problems remained. One was the question of how reliable were the estimates of the structural budget balances. Also, the new rule seemed to ban any use of discretionary fiscal policy, under any circumstances. Was this wise?

Unlike the European Union, Canada has no such fiscal rule. Neither the federal government nor many provincial governments are required to run a balanced budget. So the federal and provincial governments could, and did, run an expansionary fiscal policy to stimulate the economy in response to the financial crisis of 2008. This is why Canada was affected less severely than the European Union was.