30.11.2009   The Panalyst Perspective

Budget Deficits: What are they and do they matter?

During the recent crisis, as tax revenues have fallen and stimulus packages have grown, the state of government finances and their growing budget deficits have come under more media scrutiny. But why do they matter?

In a given year, if the government is spending more than it is earning through tax revenues, it is running a budget deficit (Currently around 6% of GDP (Gross domestic product) in Poland). Accumulated deficits over years form the government debt (Expected to be around 50% of GDP this year in Poland). When the government runs a deficit it must borrow by issuing government debt or sell off assets (Poland’s upcoming privatization program).

Large long-term deficits are an issue for the following reasons:

• It has to be financed by more government debt to domestic or overseas investors and financial institutions. As levels grow and are seen as more risky, the government may have to offer higher interest rates to attract buyers, potentially requiring tax increases later.

President Obama in a recent interview was quoted as saying, “if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession.”

• Redistribution of wealth: As interest payments on the national debt rise more funds are diverted away from useful public services to servicing debt and income in the form of taxes goes from the public to holders of the debt.
• Deficits used to finance government spending on useful infrastructure such as transport, health and education can stimulate the economy in the short term and the resulting public assets can promote long term growth, but many believe the levels of waste in the public sector are high and the private sector would do better with these funds.
• Borrowing heavily from foreign governments and countries as Poland and the U.S. do, can start to affect foreign policy, with decisions distorted by financial considerations.

Poland was the only European Union country to avoid recession during the crisis and forecasts growth of around 1.2% in GDP. However the Polish government who had a pro business reputation are currently in danger of tarnishing that image in a bid to keep government debt below 55% of GDP. Above that and finance law would require damaging mandatory budget cuts. The government is considering diverting pension funds away from private schemes into the public system, an unwise short-term move that is not being well perceived by the market. The high levels of deficits and debt mean that Poland is currently well short of meeting the fiscal criteria for joining the euro (Budget deficit less than 3% of GDP). However a 2 year privatisation plan is hoped to bring in around 37 bn zloty and substantially reduce government debt.

The simple fact is that governments like consumers often don’t pay enough attention to their rising debts. In elections with the public often so focused on tax cuts and the number of hospitals built, fiscal prudence is not always rewarded, so governments often take a short term approach leaving piles of debt to the next administration.