Pearson Edexcel International Advanced Level Economics: Fiscal deficits and national debt (YEC11)

This guide follows the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11) specification, Issue 2, June 2018. It covers section 4.3.5 (The role of the state in the macroeconomy), item 3, Public sector borrowing and public sector debt, points a to c. The specification calls Units 1 and 2 the International AS content and Units 3 and 4 the additional International A2 content. Unit 4, Developments in the global economy, is therefore compulsory for the full International Advanced Level only. The specification describes its examination as a 2-hour written paper: six multiple-choice questions, a five-part data question and two 20-mark essays from a choice of three. Every country and figure below is invented for illustration.

Related pages: revision notes, practice questions, the multiplier and output gaps, fiscal and monetary policy, exam preparation, the course hub, the checklist and the free diagnostics.

What this guide covers

Spec point	You must be able to
3a	Distinguish fiscal deficits from surpluses
3a	Distinguish automatic stabilisers from discretionary fiscal policy
3a	Distinguish a fiscal deficit from the national debt
3a	Distinguish structural from cyclical fiscal deficits
3b	Explain the factors influencing the size of deficits and debts
3c	Assess the significance of deficits and debts for interest rates, debt servicing and intergenerational equity

1. Fiscal deficits and surpluses (3a)

The fiscal balance is government revenue minus government spending in one period, usually a year. A negative balance is a fiscal deficit: spending exceeds revenue and the gap is borrowed. A positive balance is a fiscal surplus: revenue exceeds spending and the surplus can repay debt or be saved.

Economists also split out interest. The primary balance is revenue minus spending excluding interest payments. It shows whether the government’s own programmes are paying for themselves, before the cost of past borrowing.

Worked example (Country K, illustrative year). Revenue is 612. Spending other than interest is 640. The debt at the start of the year is 1,300 and the average interest rate is 3%. GDP is 2,400.

Interest          = 0.03 x 1,300 = 39
Total spending    = 640 + 39 = 679
Fiscal balance    = 612 - 679 = -67   (a deficit of 67)
Deficit / GDP     = 67 / 2,400 = 2.79%
Primary balance   = 612 - 640 = -28   (a primary deficit)

Deficits are compared across time and countries as a percentage of GDP, because 67 means little without the size of the economy.

2. Automatic stabilisers and discretionary policy (3a)

Automatic stabilisers are rules already in the tax and benefit system that move the balance whenever output moves, without any new decision. Tax receipts rise in a boom, especially under progressive income tax, and unemployment benefits fall. In a slump the reverse happens. They cushion swings in aggregate demand.

Discretionary fiscal policy is a deliberate change in tax rates, spending programmes or benefit rules by the government.

	Automatic stabilisers	Discretionary policy
Decision needed	None, built into the system	Yes, a policy choice
Timing	Immediate	Lags in recognising, deciding and acting
Size of response	Fixed by existing rules	Chosen to fit the problem
Example	Benefit payments rise as firms lay off workers	A one-year cut in a sales tax rate

Chain of reasoning. Output falls by 100. Income tax at an average 30% of that income means tax receipts fall by 30. Benefits rise by 5. The balance worsens by 35 and household disposable income falls by 65, not 100. Spending falls by less than output, so the downturn is cushioned. The cost is a bigger deficit.

3. The fiscal deficit and the national debt (3a)

A deficit is a flow: it is measured over a period. The national debt is a stock: the total the government owes at a point in time, the sum of past borrowing less repayments. A deficit adds to the debt and a surplus reduces it.

Continuing Country K: the debt rises from 1,300 to 1,300 + 67 = 1,367. If nominal GDP grows 3.5% to 2,484, the debt ratio moves from 1,300 / 2,400 = 54.2% to 1,367 / 2,484 = 55.0%. The debt ratio rose even though the economy grew, because borrowing (5.2% of the debt) outpaced growth (3.5%).

A country can run a surplus and still have a high debt, and it can run a small deficit while the debt ratio falls, if GDP grows faster than the debt. Never treat the two as interchangeable.

4. Structural and cyclical deficits (3a)

A cyclical deficit arises because the economy is below its potential output, so revenue is lower and benefit spending higher than at normal activity. It disappears when output returns to potential. A structural deficit remains even when output is at potential: spending is higher than revenue at full capacity. Only policy change, or lasting growth in potential output, removes it.

Worked example (Country K). Potential output is 2,500 and actual output is 2,400.

Output gap          = 2,400 - 2,500 = -100  (-4.0% of potential)
Automatic response  = 0.30 tax + 0.05 benefits = 0.35 per unit of gap
Cyclical deficit    = 0.35 x 100 = 35
Structural deficit  = 67 - 35 = 32  (1.28% of potential output)

If output recovers to potential with no policy change, the deficit falls from 67 to 32, not to zero. A government that sees only the headline 67 may think the recovery will fix it. The cyclically adjusted figure shows that 32 needs policy action. The split rests on estimating potential output, which is uncertain, so treat it as an estimate.

5. Factors influencing deficits and debts (3b)

Factor	Effect on deficit or debt
Phase of the economic cycle	Slump widens the deficit through automatic stabilisers; boom narrows it
Growth of potential output	Faster trend growth raises revenue and shrinks the debt ratio
Interest rates	Higher rates raise interest payments on new and refinanced debt
Demographics	An older population raises pension, health and care spending
Tax and spending decisions	Tax cuts, new programmes or capital projects change the balance
Shocks and crises	Rescues of banks, war, disasters and pandemics add one-off borrowing
Tax base and compliance	A large informal economy or evasion lowers revenue
Dependence on a volatile revenue source	A fall in a commodity price cuts revenue at once
Inflation	Raises nominal GDP, so the ratio falls, but pushes up interest rates and index-linked costs
Starting debt	A large stock means large interest payments for any given rate

Debt dynamics. The debt ratio stays stable when the primary surplus (as a share of GDP) equals d(r - g)/(1 + g), where d is the debt ratio, r the average interest rate and g nominal GDP growth. Country L has d = 0.90, r = 5% and g = 2%: it needs a primary surplus of 0.90 x 0.03 / 1.02 = 2.65% of GDP. Country M has d = 0.80, r = 2% and g = 4%: it can run a primary deficit of 0.80 x 0.02 / 1.04 = 1.54% of GDP with the ratio unchanged. The gap between interest rates and growth matters as much as the deficit.

6. Significance of deficits and debts (3c)

Impact on interest rates

Government borrowing adds to the demand for loanable funds. If savings are limited, interest rates rise, which can crowd out private investment and interest-sensitive consumption. If lenders doubt that the government can repay, they demand a risk premium, so yields rise further. Effects are smaller when there is spare saving, when the central bank holds bonds, or when borrowing is in a slump with weak private demand.

Debt servicing

Debt servicing is the interest paid on debt. For Country K, 39 / 612 = 6.4% of revenue goes on interest. Suppose 40% of the debt (520) is refinanced at 6% while the rest stays at 3%.

New interest  = 0.06 x 520 + 0.03 x 780 = 31.2 + 23.4 = 54.6
Rise          = 54.6 - 39 = 15.6
Share of revenue = 54.6 / 612 = 8.9%

The extra 15.6 is an opportunity cost: it cannot fund schools or hospitals, and it widens the deficit unless taxes rise. Debt in foreign currency or held abroad adds exchange-rate risk and sends interest payments out of the economy.

Intergenerational equity

Borrowing moves the cost of today’s spending to future taxpayers. Whether that is fair depends on what the money buys. Suppose 300 is borrowed at 3% for a road that gives benefits worth 14 a year. Interest is 9 a year, so future users gain 14 - 9 = 5 a year. If the same 300 funds current benefits, future taxpayers pay 9 a year and receive no asset. Borrowing for investment can be fair because those who pay also benefit. Borrowing for current spending shifts costs to people who did not receive the benefit. Some borrowing smooths a recession that would otherwise hurt the same generation.

Judging significance

Assess any claim that debt is “too high” using these tests:

• the size relative to GDP, and the trend
• the gap between the interest rate and nominal growth
• who holds the debt (domestic or foreign) and in which currency
• the maturity: short-dated debt is refinanced soon
• the purpose: investment or current spending
• whether the deficit is cyclical or structural
• the state of the economy: borrowing in a slump differs from borrowing in a boom

Common errors

• Calling the debt “the deficit”, or adding the deficit to GDP.
• Saying all deficits are bad. A cyclical deficit in a slump is partly the stabilisers working.
• Describing automatic stabilisers as policy changes.
• Using a debt-to-GDP ratio without saying whether it is rising or falling.
• Listing “crowding out” with no chain from borrowing to interest rates to investment.
• Giving intergenerational equity as “future generations pay” without asking what they receive.

Practise on the practice questions and condense with the revision notes.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics (YEC11), Specification, Issue 2, June 2018, first teaching September 2018, published by Pearson Education Limited. Section 4.3.5, item 3 (a to c).