Public sector borrowing and debt

Key distinctions

• Fiscal (budget) deficit: government spending exceeds tax revenue in a year. Fiscal surplus: revenue exceeds spending.
• National (public) debt: the total stock of outstanding government borrowing, built up by past deficits. A deficit is a flow; the debt is a stock.
• Automatic stabilisers: tax revenues and benefit spending that change automatically with the economic cycle (in a recession, income tax receipts fall and unemployment benefits rise, cushioning AD).
• Discretionary fiscal policy: deliberate decisions to change spending or tax rates.
• Cyclical deficit: the part caused by the economic cycle; it disappears when the economy recovers.
• Structural deficit: the part that remains even when the economy is at its normal level of output; it needs policy action.

Factors influencing the size of deficits and debts

• The economic cycle (recessions raise deficits).
• Discretionary decisions on spending and taxes.
• Interest rates on existing debt.
• Demographics (ageing raises pension and health spending).
• Shocks: financial crises, pandemics, wars, natural disasters.
• Inflation and growth: nominal GDP growth reduces the debt to GDP ratio even with a deficit.

Why the size matters

• Interest rates: high borrowing may push up interest rates if lenders demand a higher return for risk, crowding out private investment.
• Debt servicing: interest payments use revenue that could fund services; high debt reduces room to respond to the next crisis.
• Intergenerational equity: future taxpayers repay borrowing that funded today's spending (fairer if it funds long-lasting investment).
• Credit ratings and confidence: risk of a debt crisis, especially if debt is in foreign currency.

Evaluation: the debt to GDP ratio, who holds the debt (domestic or foreign), the interest rate relative to the growth rate, and what the borrowing pays for all matter.

Worked example

A government's actual deficit is 6% of GDP. Economists estimate the cyclical deficit at 2.5% of GDP. Find the structural deficit.

1. Structural = actual - cyclical
2. 6 - 2.5 = 3.5

Answer: A structural deficit of 3.5% of GDP

Check yourself

1. National debt is $1,350 bn and GDP is $1,800 bn. Calculate the debt to GDP ratio.
   Show answer

   75 %. 1,350 / 1,800 x 100 = 75%.

2. National debt is $800 bn and the average interest rate on it is 3.5%. Calculate annual debt interest.
   Show answer

   $28 bn. 800 x 0.035 = $28 bn.

3. Debt is $900 bn at the start of the year and the budget deficit for the year is $54 bn. GDP at the end of the year is $1,200 bn. Calculate the end-year debt to GDP ratio.
   Show answer

   79.5 %. (900 + 54) / 1,200 x 100 = 79.5%.

4. The actual budget deficit is 4.2% of GDP and the structural deficit is 3.0% of GDP. Calculate the cyclical deficit.
   Show answer

   1.2 % of GDP. 4.2 - 3.0 = 1.2% of GDP.

5. Which is an automatic stabiliser?
   • Unemployment benefit spending rising in a recession
   • A government decision to build a new airport
   • A cut in the VAT rate announced in the budget
   • Quantitative easing
   Show answer

   Unemployment benefit spending rising in a recession. Benefit spending rises automatically when unemployment rises.

6. What is the difference between a fiscal deficit and the national debt?
   • They are the same thing
   • The debt is yearly; the deficit is accumulated
   • The deficit is a yearly flow; the debt is the accumulated stock of borrowing
   • The deficit includes only interest payments
   Show answer

   The deficit is a yearly flow; the debt is the accumulated stock of borrowing. Flow versus stock.

7. Explain why government borrowing raises issues of intergenerational equity.
   Show answer

   Borrowing today must be repaid with interest by future taxpayers, so future generations bear the cost of today's spending; this is fairer if it funds long-lasting investment that also benefits them.. Who pays and who benefits?

8. Explain why a structural deficit is more of a concern than a cyclical deficit.
   Show answer

   A cyclical deficit disappears as the economy recovers, but a structural deficit remains even at normal output, so it requires spending cuts or tax rises to remove it, and debt keeps growing otherwise.. Structural deficits do not fix themselves.

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Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)

Last updated 8 November 2026. Spotted a mistake? Tell us.