Understanding deficits — when spending outpaces revenue for a company or government

During a downward economic period, a government deficit could inject spending into the economy to turn things around.

John Baggaley/Getty

• A deficit is the shortfall between two measurements, such as earnings and spending.
• When the government spends more than it takes in as revenue, that creates a deficit.
• Not all deficits are bad, even though they can accumulate to create debt.
• Visit Insider's Investing Reference library for more stories.

A deficit can be any type of negative gap between two benchmarks. A basketball team could have a deficit of 10 points if they're down 80-70 in the fourth quarter, or you could have a personal budget deficit of $1,000 if you're bringing home $5,000 per month but spending $6,000. Oftentimes, however, the term deficit applies to governments, such as with trade deficits between two countries or budget deficits when spending outpaces tax and other revenue sources.

While a deficit implies a shortfall, you shouldn't assume that all deficits are bad or that a large deficit is automatically worse than a small deficit. Much depends on the context. And, when referring to government deficits, politics can play a role in terms of how people view the impact of deficits. 

Understanding how deficits work 

Deficits comprise two distinct measures, with one being the baseline number you're trying to reach and another being the current amount that's below that baseline. And deficits can be personal, corporate, or even governmental in nature.

For example, when spending outpaces earnings, that creates a deficit. A company might earn $1 million in revenue per year, but if they're spending $2 million annually on salaries, office space, software, etc., then they'll have a $1 million deficit. So, they'll need to come up with a way to cover that shortfall, whether that's taking on a loan or burning through savings. 

That said, this deficit might be part of a company's growth strategy, as ramping up spending could be needed to establish the company so that it's viable long-term. 

Then there are government deficits, which work a bit differently, especially at the federal level.  In general, there are two primary types of deficits to know about: budget deficits and trade deficits, which will be covered later. And as mentioned before, deficits aren't always necessarily bad — depending on who you ask. "Absence of deficits could concern the average person more than deficits themselves. This is because government deficit spending is typically employed in response to a weakening economy," says Mariano Torras, Ph.D., Chair, Department of Finance and Economics at Adelphi University.

Deficits are typically measured over distinct periods, such as quarterly or annually. Deficits create debt, but debt is a measure of what's owed at a specific point in time based on the accumulation of deficits, Torras adds.

The federal government not only has far more access generally to borrow money to cover deficits, but it can also print money to close any gaps. That's not to say that the government will definitely print more to spend as much as it wants, but it essentially gives the government more leeway to spend than an individual could. Plus, the government has more levers to pull to affect the impact of deficits, such as raising taxes to shrink deficits.

Note: The federal government has the ability to print money to shrink deficits. Even if this capability is rarely used, the option exists.

Types of government deficits 

Two of the most common types of government deficits include budget deficits and trade deficits.

Budget deficits 

A budget deficit occurs when a government spends more than it receives, primarily from taxes. This can occur at various levels of government, though some non-federal governments have rules that aim to prevent deficits, such as balanced budget amendments at the state level. In theory, that would leave state governments without a deficit or surplus, but projections might be off, or the rules might not be strict enough to avoid deficits. 

Trade deficits

With trade deficits, a country in deficit imports more goods and services than it exports to another country. 

"Most economists believe that the most important thing is that trade deficits or surpluses should not be too large. But there are some — we call them neo-mercantilists — who believe that exporting countries are stronger than importing countries. I agree with the first but also do not entirely disagree with the second," says Torras.

Note: Trade deficits aren't necessarily about winning or losing. Much depends on specifics like the size of the deficit and why it might exist, such as to feed consumer demand.

Causes 

Deficits are caused by spending more than what you take in, or by generating less than a designated benchmark. Some causes of deficits include the following scenarios:

• Purposeful deficits: In some cases, those who get into a deficit do so willingly. For example, in recent years, when the federal government sets its annual budget, it knowingly projects the annual deficit based on spending intentions outpacing projected revenue. 
• Unintentional deficits: Sometimes a government or company gets into a deficit (or a larger deficit than intended) due to unexpectedly spending more than anticipated or by collecting less revenue than planned. For example, a recession could cause tax revenues to plummet, so even if the government planned to spend less than it taxed, that might not always pan out. That's because factors such as layoffs and pay cuts can lead to less income tax collections, and stock market drops can reduce capital gains taxes.
• Lower production: Deficits can also be caused by simply not having or producing as much as someone else, such as in the case of a points deficit in sports. Or, a government could have a trade deficit with another country if it exports more than it imports. 

Real-world example of a deficit 

In 2020, ​​the US exported $164.9 billion to China and imported $450.4 billion. So, the 2020 US trade deficit with China totaled $285.5 billion, as it's the difference between the imports and exports. 

Trade deficits between countries can sometimes take on more political weight, such as when the Trump administration instituted tariffs in an attempt to try to shrink the trade deficit between the US and China, among other trade partners. In response, however, countries like China placed tariffs of their own on US exports, making it harder to shrink the trade deficit.

The financial takeaway

Overall, deficits represent shortfalls, but that's not always a bad thing. Owing money due to a deficit does matter, but it could be a purposeful strategy, such as if a company is in growth mode and needs to spend a lot to grow market share before it can become profitable.

For the government, deficits can also potentially be positive. During a down economic period, for example, a government deficit could inject spending into the economy to turn things around. A trade deficit also isn't necessarily worse than a surplus, especially if imports enable a country to gain much needed resources.

Read the original article on Business Insider

Contributer : Business Insider https://ift.tt/3HXqwEy

Something that you might miss to see?