What is the Government Budget Constraint ?
Generally, the government finances its expenditure through the revenue received from taxes (both direct and indirect). When government expenditure exceeds its revenue received from taxes, it can finance its expenditure by borrowing money from the market or by printing new money.
The government has the power to increase taxes to increase revenue but increase in the rates of taxes adversely affects the incentives to work more, save and invest. Increase in taxes also promotes tax evasion. So, there are limits to increasing revenue from taxes to finance the increased expenditure of the government.
When government finds it difficult to raise adequate resources to finance its increased expenditure fully through normal taxes, it faces a constraint which is called Government Budget Constraint, which results in budget deficit also called fiscal deficit.
In simple terms, government budget constraint refers to the limit placed on the government expenditure to which it can raise resources through taxation, borrowings from the market and using printed money.
The general form of government budget constraint is
G = T + ∆B + ∆M
G = Government expenditure (including subsidies and interest payments on past debt)
T = Tax revenue
∆B = New borrowing from market (by the sale of bonds or securities)
∆M = New printed money issued to finance government expenditure
(∆M is also called High Powered Money or Money Financing)
The government has to make a choice between the magnitude of T, ∆B and ∆M to finance its budget deficit.
Equation of the government budget constraint can also be written as
G – T = ∆B – ∆M
G – T = Budget Deficit or Fiscal Deficit
Budget Deficit or Fiscal Deficit = New Market Borrowing by Government + New Printed Money
The government budget (fiscal) deficit can be financed either by printing new money by the government or by selling bonds to the public (which includes banks, mutual funds, insurance companies and other financial institutions). The government borrows from the market by selling bonds or securities which adds to the government debt. The government has to pay interest annually on its debt and also have to pay back the principal amount borrowed at the maturity of bonds or securities. Borrowing by the government also leads to the rise in interest rates which crowds out (discourages) private investment.
If the government finances its budget deficit by printing new money, it can lead to inflation. Therefore, due to budget constraint, the government has to make choice between borrowing from the market and using printed money to finance its budget deficit. Financing by new printed money is also called Money Financing.