Definition of budget balance
A balanced budget occurs when an entity’s spending matches its revenue during a period of time. An excess of revenue over spending is referred to as a budget surplus and an excess of spending over revenue is referred to as a budget deficit. On average over time healthy governments run balanced budgets. Persistent government deficits lead to a crisis of confidence in the ability of a government to pay back its debt.
Indeed, membership in the European Union requires countries to limit their budget deficits to 3 per cent of GDP. Unfortunately, in 2009 these limits have been exceeded by Greece, Portugal, Ireland, Spain, Italy and the UK.
Persistent government deficits lead to an accumulation of government debt, which leads to a high and rising ratio of government debt to GDP (referred to as a country’s debt-to-GDP ratio). From 1980 until 2010 the debt-to-GDP ratio in the US rose from 26.1% to 62.2%, without any clear need for spending to exceed revenue during this entire time period.
Governments have sometimes run budget deficits to avoid high tax rates in the face of uncertain spending and revenue. Typically, a government will run a budget deficit during periods in which spending is unusually high relative to revenue, such as times of war or recession.
For instance, to finance World War II, the US ran a large budget deficit so that its debt as a fraction of GDP rose from 44.2% in 1940 to 108.6% in 1946. This debt-to-GDP ratio fell to 26.1% by 1980. In the UK, public debt rose to 238% of GDP in 1947 and fell to 42% by 1980.