Government Deficits and the National Debt: Study Guide (Macroeconomics 5.4)

The government budget

Every year a government collects tax revenue and spends money. It spends in two main ways:

• Government purchases (G): spending on goods and services, such as roads, schools, soldiers’ pay and medicines for public hospitals. G is the part that enters GDP.
• Transfer payments: payments that buy no good or service, such as pensions, unemployment benefits and student grants.

The budget balance compares the two sides for one year:

Budget balance = tax revenue − (government purchases + transfer payments)

• If the balance is positive, the government has a budget surplus. It collected more than it spent.
• If the balance is negative, the government has a budget deficit. It spent more than it collected.
• If the balance is zero, the budget is balanced.

A government that already owes money must also pay interest to the people and institutions that lent to it. Interest buys no good or service, so it is not part of G. In the budget, though, it is spending, just like a transfer payment. In this guide we list interest on its own line and add it to spending:

Budget balance = T − (G + transfer payments + interest)

If a question gives “government spending” as one figure, use that figure as the whole of the spending side.

How a deficit is paid for

If spending is greater than tax revenue, where does the extra money come from? The government borrows. It sells government bonds (Topic 4.1) to households, firms, banks and foreign lenders. Each bond is a promise to repay the amount borrowed, with interest.

So every deficit means new borrowing. That borrowing is what builds up the national debt.

Deficit and debt: flow and stock

Students often mix up these two words. They measure different things.

	Budget deficit	National debt
Type of measure	Flow: measured over a period	Stock: measured at a point in time
Time	One year	The total built up over many years
Meaning	How much more the government spent than it collected this year	How much the government owes in total right now
Example	“Valdoria’s deficit in 2023 was VD 40 billion.”	“On 31 December 2023 Valdoria owed VD 640 billion.”

Think of a bath. The deficit is water flowing in from the tap this year. The debt is the water already in the bath. A smaller flow still raises the water level. Only a surplus, which pulls the plug a little, lowers it.

The link between them:

Debt at the end of the year = debt at the start of the year + deficit for the year

Debt at the end of the year = debt at the start of the year − surplus for the year

So a government adds to the national debt whenever it runs a deficit, and it can reduce the debt only by running a surplus and using it to repay lenders.

Worked example 1: budget balances and the debt

Valdoria is the fictional country used across the Marlbridge macroeconomics pages. Its currency is the valda (VD). At the start of 2023, Valdoria’s national debt is VD 600 billion. The table shows its budget for four years, in VD billion (all figures fictional).

Year	Tax revenue	Government purchases	Transfer payments	Interest on the debt
2023	300	240	70	30
2024	315	250	72	32
2025	340	252	70	34
2026	380	255	72	35

Question. (a) Calculate the budget balance for each year and say whether it is a surplus or a deficit. (b) Calculate the national debt at the end of each year. (c) Describe what happened to the debt in 2025, and explain why.

(a) Step 1: total spending = G + transfers + interest.

• 2023: 240 + 70 + 30 = 340
• 2024: 250 + 72 + 32 = 354
• 2025: 252 + 70 + 34 = 356
• 2026: 255 + 72 + 35 = 362

Step 2: balance = tax revenue − total spending.

• 2023: 300 − 340 = −40, a deficit of VD 40 billion
• 2024: 315 − 354 = −39, a deficit of VD 39 billion
• 2025: 340 − 356 = −16, a deficit of VD 16 billion
• 2026: 380 − 362 = +18, a surplus of VD 18 billion

(b) Debt at end of year = debt at start − balance (subtracting a negative balance adds the deficit).

Year	Debt at start	Balance	Debt at end
2023	600	−40	640
2024	640	−39	679
2025	679	−16	695
2026	695	+18	677

(c) In 2025 the deficit fell sharply, from VD 39 billion to VD 16 billion. But the debt still rose, from VD 679 billion to VD 695 billion, because any deficit has to be borrowed. The debt first fell in 2026, the only year with a surplus.

Check. Over the four years the balances add up to −40 − 39 − 16 + 18 = −77. The debt rose by 677 − 600 = 77. The two must match.

Notice also that interest was about 5% of the debt at the start of each year (30 is 5% of 600; 32 is 5% of 640). As the debt grew, so did the interest bill. Without interest, the 2025 budget would have been in surplus (340 − 252 − 70 = +18).

Why deficits happen

Deficits are not always a sign of bad management. Some come from deliberate choices and some happen on their own.

• Expansionary fiscal policy (Topic 3.8): raising G, raising transfers or cutting taxes to fight a recession all push the budget towards deficit.
• Automatic stabilizers (Topic 3.9): in a recession, incomes fall, so tax revenue falls, and more people claim unemployment benefits, so transfers rise. The deficit grows without any new decision.
• Interest on past debt: the larger the debt, the larger the interest bill, and the harder it is to balance the budget.

In a boom the opposite happens: tax revenue rises, transfers fall, and the budget moves towards surplus.

The burden of the national debt

A government must pay interest on everything it has borrowed and not yet repaid. This creates several problems.

1. Interest uses funds that have other uses. Every valda spent on interest is a valda that cannot be spent on schools, hospitals or roads, or returned to households as a tax cut. This is an opportunity cost. In 2023, Valdoria spent VD 30 billion on interest, which is 10% of its tax revenue.

2. Interest can make the debt grow by itself. If the government cannot cover its interest from taxes, it must borrow to pay it. The borrowed interest adds to the debt, and next year the government pays interest on that too. The debt then grows even when the government spends nothing new.

3. Future taxpayers carry the cost. To pay interest and repay the debt, future governments must raise taxes, cut spending or borrow even more.

4. Borrowing may crowd out private investment. When the government borrows, it competes with firms for loanable funds. This can raise the real interest rate and reduce private investment, which can slow the growth of the capital stock. You will study this in detail in Topic 5.5, Crowding Out.

Worked example 2: the cost of interest

Question. (a) A government with a debt of VD 500 billion pays 6% interest. It balances its budget before interest each year, and borrows to pay all of the interest. Calculate the debt at the end of each of the next three years. (b) Valdoria’s debt at the end of 2026 is VD 677 billion (Worked example 1). If the average interest rate on its debt rises from 5% to 7%, by how much does the yearly interest bill rise? What could that money have paid for?

(a) Each year: interest = debt at start × 0.06, and the debt rises by the interest.

Year	Debt at start	Interest (6%)	Debt at end
1	500.00	30.00	530.00
2	530.00	31.80	561.80
3	561.80	33.71	595.51

The debt rises by VD 95.51 billion in three years, even though, apart from interest, the government never spends more than it collects in taxes. The interest grows each year because the government pays interest on the interest it borrowed before. Over three years this costs VD 5.51 billion more than three payments of VD 30 billion.

(b) Interest at 5%: 677 × 0.05 = VD 33.85 billion. At 7%: 677 × 0.07 = VD 47.39 billion. The interest bill rises by VD 13.54 billion a year.

That is about 18.8% of Valdoria’s 2026 transfer payments (13.54 ÷ 72 × 100). The government must find this money by cutting other spending, raising taxes or borrowing more, which would add to the debt again. Interest would now take 47.39 ÷ 380 × 100 = 12.47% of 2026 tax revenue, up from about 9%.

Interpretation. A large debt makes the budget sensitive to interest rates. The bigger the debt, the more of each year’s revenue goes to past borrowing instead of present needs.

Background (not required). Economists often compare a country’s debt with its GDP, because a larger economy can carry a larger debt. You are not asked to calculate this ratio in this course.

Common misconceptions

• “Deficit and debt mean the same thing.” The deficit is one year’s shortfall (a flow). The debt is the total owed (a stock).
• “A smaller deficit means the debt is falling.” The debt still rises, just more slowly. It falls only with a surplus.
• “A surplus means the government has no debt.” A surplus only reduces the debt by the amount of the surplus. Valdoria’s 2026 surplus of VD 18 billion left a debt of VD 677 billion.
• “Transfer payments do not count because they are not in GDP.” They are not in G, but they are government spending in the budget. Include them.
• Forgetting interest. Interest on the debt is spending in the budget. Leaving it out understates the deficit.
• “Interest on the debt is free if the government just borrows it.” Borrowed interest adds to the debt, so next year’s interest bill is higher.
• Getting the sign wrong. Tax revenue minus spending: a negative number is a deficit.

Where this leads

Next, Topic 5.5 shows on a loanable funds graph how government borrowing to finance a deficit can raise the real interest rate and crowd out private investment. Read the Crowding Out study guide after this one. To check this topic, try the practice questions, then use the revision notes and the checklist. The previous topic, Money Growth and Inflation, covered the long-run results of monetary policy; this topic and the next cover the long-run results of fiscal policy.