The Government Budget at a High Level

While it's interesting to consider the variety of activities that governments fund, it's important to start at a high level and think about the basic mechanics of a government's budget situation.  Put simply, a government collects money in taxes and spends money either by purchasing various goods and services or by transferring money to individuals in the economy.  (Note that when we talk about "government spending" in the context of aggregate production and income, we are not including transfer payment since they don't involve any production or output.)

Economists generally refer to the aggregate amount of tax revenue in an economy as T, the amount a government spends on goods and services as G, and the amount that a government transfers to individuals as TR. 

A Balanced Government Budget

A government is said to be running a balanced budget when the amount that it takes in in taxes is equal to the amount that it pays out within a given budget period (usually a year).  In terms of the quantities that we've defined, a government runs a balanced budget when T is equal to G plus TR.

There is no particular reason, however, that the government has to, or even should, match tax revenue to outlays each period, so it's important to also think about situations where a balanced budget is not present.

A Government Budget Deficit

A government is said to be running a budget deficit when it pays out more than it takes in.  In terms of the quantities that we've defined, a budget deficit exists in a given period  if T is less than the sum of G and TR.  Equivalently, a budget deficit exists when T - (G + TR) is less than zero.

When a government runs a budget deficit, it needs to borrow in order to make up the difference.  Governments borrow from domestic and foreign citizens by issuing various forms of Treasury bonds, which offer to pay interest at a later date in return for citizens loaning money to the government.

Budget Deficits and the National Debt

A budget deficit refers to a mismatch between tax revenue and government expenditures in a single time period  We can also define a quantity that represents the accumulation of these deficits over time.  The national debt gives the total amount that the government owes to lenders, and it can be thought of as the summation of all historical deficits.  In other words, each time a deficit is incurred, the amount of the deficit is added to the national debt.

Despite what it may seem like you hear in the news, governments don't always incur budget deficits   A budget surplus occurs when a government takes in more in taxes than it pays out in spending and transfers.   In terms of the quantities that we've defined, a budget surplus exists in a given period  if T is greater than the sum of G and TR.  Equivalently, a budget surplus exists when T - (G + TR) is greater than zero.

Whereas budget deficits add to the national debt, budget surpluses subtract from the national debt.  This is because the tax revenue that is not used for purchases or transfers can be used to pay back some of the money that it owes to lenders.  (This generally happens not by the government paying back the bonds early but instead letting some bonds mature and not issuing new ones to replace them.)

In general, budget deficits tend to increase during recessions, or periods of reduced economic activity.  There are two reasons for this that don't have to do with active decisions of policymakers.  First, most tax system are structured such that taxes are an increasing function of income.  Therefore, when income decreases during a recession, the amount of revenue that the government collects in taxes decreases as well.

 This will shift the government toward running a deficit even if spending or transfers don't change.

Second, there are a number of transfer payments to citizens that tend to increase during periods of reduced economic activity- unemployment payments are one good example of this. These countercyclical payments also shift the government towards running a deficit.