Economists note that the automatic stabilisers in the government's budget increase deficits (or reduce surpluses) in times of slack aggregate demand. This sensitivity of the budget outcome to the business cycle could be eliminated if the government followed a fiscal rule such that it had to balance its budget at all times.
Answer: False
The answer is False.
The final budget outcome is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the budget balance is used by all and sundry to indicate the fiscal stance of the government.
So if the budget is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit we say the fiscal impact expansionary (adding net spending).
Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance - which, in turn, creates such income losses that the automatic stabilisers start driving the budget back towards (or into) deficit.
So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.
To see this, the most simple model of the budget balance we might think of can be written as:
Budget Balance = Revenue - Spending = (Tax Revenue + Other Revenue) - (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the budget balance are the so-called automatic stabilisers.
In other words, without any discretionary policy changes, the budget balance will vary over the course of the business cycle. When the economy is weak - tax revenue falls and welfare payments rise and so the budget balance moves towards deficit (or an increasing deficit). When the economy is stronger - tax revenue rises and welfare payments fall and the budget balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.
So just because the budget goes into deficit doesn't allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
The first point to always be clear about then is that the budget balance is not determined by the government. Its discretionary policy stance certainly is an influence but the final outcome will reflect non-government spending decisions. In other words, the concept of a fiscal rule - where the government can set a desired balance (in the case of the question - zero) and achieve that at all times is fraught.
It is likely that in attempting to achieve a balanced budget the government will set its discretionary policy settings counter to the best interests of the economy - either too contractionary or too expansionary.
If there was a balanced budget fiscal rule and private spending fell dramatically then the automatic stabilisers would push the budget into the direction of deficit. The final outcome would depend on net exports and whether the private sector was saving overall or not. Assume, that net exports were in deficit (typical case) and private saving overall was positive. Then private spending declines.
In this case, the actual budget outcome would be a deficit equal to the sum of the other two balances.
Then in attempting to apply the fiscal rule, the discretionary component of the budget would have to contract. This contraction would further reduce aggregate demand and the automatic stabilisers (loss of tax revenue and increased welfare payments) would be working against the discretionary policy choice.
In that case, the application of the fiscal rule would be undermining production and employment and probably not succeeding in getting the budget into balance.
But every time a discretionary policy change was made the impact on aggregate demand and hence production would then trigger the automatic stabilisers via the income changes to work in the opposite direction to the discretionary policy shift.
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