AQA A-level Economics: Budget balance, national debt and deficits (7136)

This guide covers the budget balance and national debt points of the Fiscal policy sub-section of AQA A-level Economics (7136), specification version 1.3, section 4.2.5.1 (numbered 3.2.5.1 on the AQA website). It teaches the balance, the debt, cyclical and structural positions, consequences, the size of the debt, the Office for Budget Responsibility and rebalancing. Spending, tax types and the policy tools are taught elsewhere, so they appear here only where the argument needs them. Every country, firm and figure below is invented and illustrative. Course pages: AQA A-level Economics hub, checklist and free diagnostics. Next: the revision notes and the practice questions. Related: aggregate demand and supply.

What the specification asks for

Content point	What you must be able to do
Budget balance and national debt	Define both and explain how they connect
Cyclical and structural balances	Separate the part due to the cycle from the part that is built in
Consequences for macroeconomic performance	Trace effects of deficits and surpluses on growth, jobs, prices, the current account
Size of the national debt	Judge when a given debt is a problem
Office for Budget Responsibility	Explain its role
Evaluation	Discuss deficits and surpluses, and assess measures that rebalance the budget

1. Budget balance and national debt

The budget balance is government revenue minus government spending over a period, usually a year. If spending exceeds revenue there is a budget deficit; if revenue exceeds spending there is a budget surplus. The national debt is everything the government owes on a given date: past borrowing less repayments. The balance is a flow. The debt is a stock.

The link: a deficit adds to the debt, and a surplus lets the government repay some. Interest on the debt is itself spending, so a large debt makes a deficit harder to close. The primary balance is revenue minus spending excluding interest.

Worked example (Country A, illustrative year). Revenue is 420. Spending other than interest is 420. Opening debt is 720, average interest is 5%, GDP is 1,200.

Interest         = 0.05 x 720 = 36
Total spending   = 420 + 36 = 456
Budget balance   = 420 - 456 = -36   (a deficit of 36)
Deficit / GDP    = 36 / 1,200 = 3.0%
Primary balance  = 420 - 420 = 0
Closing debt     = 720 + 36 = 756

Country A has no primary deficit: the whole deficit is interest on past borrowing. Debt is judged against GDP. Opening debt/GDP is 720 / 1,200 = 60.0%. If nominal GDP grows 3% to 1,236, the closing ratio is 756 / 1,236 = 61.2%. The ratio rose because the debt grew by 5.0% (36 / 720) while GDP grew by 3%.

Now Country B: GDP 1,000, debt 900 (90%), interest 2%, revenue 380, non-interest spending 392. Interest is 18, spending is 410 and the deficit is 30, also 3.0% of GDP. If nominal GDP grows 4% to 1,040, the closing ratio is 930 / 1,040 = 89.4%. Country B has a higher debt ratio and the same deficit ratio, yet its ratio is falling, because growth (4%) beats the interest rate (2%). Compare the interest rate with nominal growth, not just the deficit.

2. Cyclical and structural balances

A cyclical deficit (or surplus) arises from the economic cycle. When output is below potential, tax receipts fall and spending on benefits rises without any new decision. In a boom the reverse happens, so a cyclical surplus can appear. A structural deficit (or surplus) is what remains when output is at potential: spending and revenue are out of line even in normal conditions. Removing it takes a change in policy or sustained expansion of productive capacity.

Worked example (Country A). Potential output is 1,275 and actual output 1,200, so the output gap is 75 (5.9% of potential). Suppose each unit of lost output cuts tax revenue by 0.26 and raises benefit spending by 0.06.

Automatic effect per unit of gap = 0.26 + 0.06 = 0.32
Cyclical deficit   = 0.32 x 75 = 24
Structural deficit = 36 - 24 = 12   (0.9% of potential output)
Structural primary = 0 + 24 = a surplus of 24

If output returned to potential with no policy change, the deficit would fall from 36 to 12, not to zero. The structural primary position is a surplus, so the structural deficit (12) is smaller than the interest bill (36). A government that treated the headline 36 as a spending problem would cut too hard. Caveat: potential output cannot be observed, so the split is an estimate.

3. Consequences of a budget deficit

Use chains of reasoning, then weigh them.

Aggregate demand and the multiplier. Higher government spending or lower taxes raise aggregate demand (AD). Suppose households save 10%, the tax system takes 25% and imports are 15% of each extra unit of income. Withdrawals are 0.10 + 0.25 + 0.15 = 0.50, so the multiplier is 1 / 0.50 = 2. Extra spending of 12 raises income by 24. Extra tax of 0.25 x 24 = 6 comes back, so the deficit rises by 12 - 6 = 6, half the original spending. Deficit-financed spending partly pays for itself when output is below potential.

Growth, jobs and prices. With spare capacity, higher AD raises real output and cuts cyclical unemployment with little price pressure. Near full capacity, the extra demand is mainly inflationary.

Current account. Higher AD also raises spending on imports (the 0.15 above). A deficit can therefore widen a current account deficit, the so-called twin deficits link. It is not automatic: if the deficit funds investment that raises exports, the link weakens.

Interest rates and crowding out. Government borrowing competes with firms for a limited pool of saving. Interest rates may rise, and private investment then falls. This is crowding out. It is weak in a recession, when firms want to borrow little and savings are plentiful.

Aggregate supply. Borrowing for infrastructure, education or research can raise long-run aggregate supply (LRAS) and trend growth. Borrowing for current spending leaves no asset behind.

Debt interest and confidence. A rising debt raises interest payments, which divert money from other spending. If lenders doubt repayment, they demand higher yields, and borrowing costs rise for everyone.

4. Consequences of a budget surplus

A surplus withdraws demand from the circular flow, so AD is lower than it would otherwise be. When the economy is overheating, this reduces inflationary pressure. In a weak economy it deepens a slowdown and raises unemployment. A surplus lets the government repay debt, so interest payments fall and lower interest rates may result, which can encourage investment. It also creates room to cut taxes, raise spending or respond to a future shock without panic borrowing. The costs: possible under-provision of public services and infrastructure, and a drag on growth if the surplus comes from squeezing demand. A cyclical surplus in a boom is normal. A structural surplus is a deliberate choice.

5. The size of the national debt

A large debt is not automatically a problem. Weigh these:

Test	Lower risk	Higher risk
Debt / GDP and trend	Low or falling	High and rising
Interest rate against nominal growth	Rate below growth	Rate above growth
Interest as a share of revenue	Small	Large, so less for services
Holders and currency	Domestic holders, own currency	Mainly foreign holders, foreign currency
Maturity	Long-dated	Short-dated, refinanced soon
Purpose	Investment that raises output	Current spending
Economic state	Slump, with spare capacity	Boom, with crowding out

For Country A, interest takes 36 / 420 = 8.6% of revenue. If that share doubled, it would absorb money that could pay for schools or hospitals and would force tax rises or cuts elsewhere. That is the opportunity cost of debt. There is also an intergenerational point: debt that paid for a road still used in 30 years is shared fairly, but debt that paid for current spending passes the bill to people who got nothing.

6. The role of the Office for Budget Responsibility

The OBR is an independent body, created in 2010, that provides analysis of the UK’s public finances. Its main roles are producing economic and fiscal forecasts to accompany Budget announcements, assessing the government’s performance against its fiscal targets, assessing the long-term sustainability of the public finances, evaluating fiscal risks and scrutinising the costings of tax and welfare policies. It does not set policy. Because the forecasts come from outside the government, they are harder to bend towards optimism, which makes the targets more believable to lenders and voters. Weakness: forecasts of growth and revenue are uncertain and are revised, so a government can meet a target on paper and miss it in practice.

7. Measures to rebalance the budget

Two routes: cut spending or raise revenue. A third raises growth so that revenue rises.

Worked example (Country A, multiplier 2, induced tax rate 0.25).

Cut spending by 12:  income falls 12 x 2 = 24
                     tax revenue falls 0.25 x 24 = 6
                     deficit falls 12 - 6 = 6        (half the cut)
Raise tax by 12:     households spend 75% of lost income domestically,
                     so AD falls 9, income falls 9 x 2 = 18
                     tax revenue falls 0.25 x 18 = 4.5
                     deficit falls 12 - 4.5 = 7.5

Both policies slow growth, and the deficit falls by less than the headline cut. In this example the tax rise improves the balance more because households cut some saving and imports. This depends on the assumption in the example.

Points to weigh: cuts to capital spending harm future supply; cuts to benefits hit lower earners and the stabilisers; tax rises can reduce incentives; timing matters, since tightening in a recession deepens it; a credible plan may lower interest rates and raise confidence; and growth-led rebalancing is slow but painless. Structural deficits need lasting measures. Cyclical deficits may need only patience. A well-judged answer links the measure to the type of deficit, the state of the cycle and the size of the multiplier.

Common errors

• Writing “deficit” when you mean “debt”, or the reverse.
• Calling every deficit bad, or every surplus good.
• Using a debt figure without GDP, the interest rate or growth.
• Forgetting that a cut in spending also reduces tax revenue.
• Describing the OBR as setting taxes or targets.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, published by AQA. This guide follows the A-level content in section 4.2.5.1.