Economics, 3rd Edition

Argument 2: The Idea of a Structural Deficit is a Myth 

The idea that government deficits are structural 

is  unhelpful. The assumption is that governments have to borrow more because of the gap between 

income and expenditure but how certain can we be that the only reason governments are borrowing 

money is simply due to the changes to public finances wrought by the recession? The whole notion of a 

structural deficit assumes that it is the amount governments borrow when the economy is operating at 

its trend level. This implies that to measure it we need to know how far the economy is operating below 

trend – the output gap.

The problem is that there is considerable disagreement on the size of the output gap. It is accepted that 

the recession will have destroyed some potential output but how much is open to some interpretation. 

There have been a number of studies attempting to quantify the impact of economic downturns on the 

output gap and the outcomes vary significantly. In the UK the Institute for Fiscal Studies (IFS) has estim-

ated that the output loss of the economic downturn from 2008 could be as much as 7.5 per cent whereas 

the Treasury  estimates  5 per cent and other estimates put the gap as low as 2 per cent.

The size of the output gap is important because it has a direct effect on the cyclical component of the 

deficit – the larger the output gap the larger will be the cyclical component and the smaller the structural. 

This in turn affects any estimates of the size of borrowing when the economy does return to trend – in 

other words, the size of the structural deficit. Any calculations on the deficit would also be subject to 

assumptions about the sensitivity of taxes and spending to changes in GDP. How does tax revenue rise in 

relation to changes in GDP? This will depend in part on assumptions about the number of people who are 

able to find work as the economy expands but also on the extent to which potential output has been des-

troyed. How do changes in government spending vary in relation to changes in GDP? How many people 

will get off benefits and what effect will short-term fiscal stimulus measures have on spending?

As an increasing number of assumptions are made, calculations of the size of the structural deficit 

could be very different; which one should be used as the basis for policy decisions? In the light of this 

analysis is it useful to think of the idea of a structural deficit at all?

SELF TEST 

Explain why inaccurate information might affect forecasts of economic growth and thus the size 

of government budget deficits.