What are the Budget Constraints Faced by the Government?

We begin by being careful and precise about terminology. The terms deficit and debt are sometimes used sloppily in everyday discourse; as a consequence, much nonsense is spoken about fiscal policy. We must first make sure that we understand exactly what these terms mean. [1] Budget Deficit: Definition The government deficit is the difference between government outlays and government revenues. Inflows and outflows are part of the circular flow of income. Revenues flow to the government when it imposes taxes on households and firms and when it collects money through various other fees. For our purposes here, we do not need to distinguish all the different kinds of taxes, and we do not worry about whether they are paid by firms or by households. All that matters is that, in the end, some of the income generated in the economy flows to the government. [2] Money flows out in the form of government purchases of goods and services and government transfers. Government purchases include things like roads, streetlamps, schools, and missiles. They also include wage payments for government employees—that is, the purchase of the services of teachers, soldiers, and civil servants. Outlays also occur when government gives money to households. These are called transfer payments, or transfers for short. Examples include unemployment insurance, Social Security payments, and Medicare payments. Finally, transfers include the interest payments of the government on its outstanding obligations. The outlays of the government and its revenues are not always equal. The difference between government purchases and transfers and government revenues represents a government deficit, as set out in the following definition: government deficit = outlays – revenues= government purchases + transfers − tax revenues= government purchases − (tax revenues − transfers)= government purchases − net taxes. Often we find it useful to group taxes and transfers together as “net taxes” and separate out government purchases, as in the last line of our definition. When outflows are less than inflows, then we say there is a government surplus. In other words, a negative government deficit is the same thing as a positive government surplus, and a negative government surplus is the same thing as a positive government deficit: government surplus = −government deficit. A government surplus is sometimes called “government savings.” When the government runs a deficit, borrowing from the financial markets funds such spending.