When a government’s total outgoings (G) are more than their tax receipts (T), the result is a budget deficit where G > T. A government needs to borrow money to finance the debt, and interest payments can become so large that they cripple the economy.
There are two main schools of thought for eliminating the deficit and arriving at a balanced budget.
Option 1 – the UK way: cut G so the budget balances
In 2010, the UK announced the biggest spending cuts for decades, hitting welfare, council and police budgets. These continuing cuts have come to be known as austerity and are supposed to reduce the level of G, allowing a balanced budget where G = T.Cutting back on public expenditure means reducing spending on items such as schools or hospitals. It could also mean cuts in welfare transfers and unemployment benefits. The deficit is reduced, resulting in a balanced budget.
The UK deficit has been cut in terms of a percentage of national income (money in the economy). However, the reduction in government spending has had a negative side effect: national income has been diminished, and we have a smaller economy.
Option 2 – the Uganda way: boost G so that T increases and the budget balances
In June 2017, Uganda announced plans to increase spending by 10 per cent to USh29 trillion ($8.09 billion) to support flagging economic growth. ‘As result of these actions, the economy is expected to rebound to annual growth rates of 7 per cent in the medium term, as a minimum,’ said the Ugandan Finance Minister Matia Kasaija. The government will borrow USh954 billion from the domestic market to pay for this.
Can you spend your way out of a deficit? The Ugandan government is banking on the work of the multiplier effect where one person’s spending is another person’s income.
In economics, a multiplier is the factor by which gains in the national income are greater than the change in spending that caused it. In the 1930s, economist John Maynard Keynes suggested that government spending could increase national income in the following way.
- The government invests in the petroleum business. (Oil has recently been discovered in Uganda.)
- Firms in the construction business win contracts to build oil rigs and see their incomes and profits increase.
- The oil rig employees save a proportion and spend a proportion of that additional income on buying new cars.
- The automobile businesses see a rise in their profits.
- The automobile business employees save a proportion and spend a proportion of that additional income on eating out.
- The restaurant owners see a rise in their profits.
- The restaurant employees save a proportion and spend a proportion of that additional income on eating out.
- The process carries on until the spending runs out, with the initial amount having multiplied through the economy.
An injection of government spending will therefore have a larger impact on economic activity than the amount initially put in. This increases national income which increases tax receipts T, reduces unemployment benefits, and allows a balanced budget where G = T.
Will Uganda’s approach work? What do you think?