Understanding How Budget Deficits Grow During Recessions

Government Spending and Economic Activity

Jamie Grill/Getty Images

There is a relationship between budget deficits and the health of the economy, but is certainly not a perfect one. There can be massive budget deficits when the economy is doing quite well, and, though somewhat less likely, surpluses are certainly possible during bad times.  This is because a deficit or surplus depends not only on the tax revenues collected (which can be thought of as proportional to economic activity) but also on the level of government purchases and transfer payments, which is determined by Congress and need not be determined by the level of economic activity.

That being said, government budgets tend to go from surplus to deficit (or existing deficits become larger) as the economy goes sour. This typically happens as follows:

  1. The economy goes into recession, costing many workers their jobs, and at the same time causing corporate profits to decline. This causes less income tax revenue to flow to the government, along with less corporate income tax revenue. Occasionally the flow of income to the government will still grow, but at a slower rate than inflation, meaning that flow of tax revenue has fallen in real terms.
  2. Because many workers have lost their jobs, their dependency is increased use of government programs, such as unemployment insurance. Government spending rises as more individuals are calling on government services to help them out through tough times.  (Such spending programs are known as automatic stabilizers, since they by their very nature help stabilize economic activity and income over time.)
  1. To help push the economy out of recession and to help those who have lost their jobs, governments often create new social programs during times of recession and depression. FDR's "New Deal" of the 1930s is a prime example of this. Government spending then rises, not just because of increased use of existing programs, but through the creation of new programs.

    Because of factor one, the government receives less money from taxpayers due to a recession, while factors two and three imply that the government spends more money than it would during better times. Money starts flowing out of the government faster than it comes in, causing the government's budget to go into deficit.