Every federal, state, and local budget is a social contract between the government and its people. The budget is a document that state’s the values and priorities, especially those of the president. Federal financial authority comes from the U.S. Constitution. Article 1, Section 8 states: “the Congress shall have the power to levy and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the Common Defense and General Welfare of the United States.” Federal taxing authority and the broad responsibility for the country’s defense and general welfare is at the heart of the budget. “General welfare” has been broadly interpreted and serves as the justification for programs as different as space exploration, transfer payments to low-income citizens, road building, and wildlife preservation.
The Federal Budget Process
Before we can talk about federal deficits, it would be of value to briefly discuss the budget process. There are three stages in the federal budgetary process.
Stage 1: Formation of the Budget. The budget process begins each spring when the president asks for budget requests from the various government agencies. These agencies, such as the Department of Defense and the Department of Transportation, submit their budgets to the Office of Management and Budget (OMB). Remember, that the government’s fiscal year begins on October 1 and ends on September 30th of the following year. After consultation with the Council of Economic Advisors and the Treasury, the OMB sends a budget recommendation to the president in the fall.
Stage 2: Presidential Budget Submission. The president must send his budget to Congress by January. There is usually a great deal of fanfare when the President reveals his budget. The priorities of the President are often seen in the what is given high priority in the budget, and what is left out.
Stage 3. Budget Resolution. When Congress receives the budget, they send it the Congressional Budget Office (CBO) for review. The CBO analyzes the budget and reports its evaluations to the Budget Committees in each house. In September, Congress is supposed to pass a budget resolution that is binding.
Since the Budget Reform Act of 1974, the federal fiscal budget year runs from 1 October to 30 September and is known by the year in which the budget ends (for example, Fiscal Year 2017 ended on 30 September 2017). Although we often think of Congress as having the “powers of the purse,” the federal budget requires the president and Congress to work together. The power of a presidential veto is great since a single party rarely has the two-thirds majority vote necessary for a veto override.
The Debt Ceiling
Federal law requires Congress to authorize the government to borrow any money that is needed to pay for the programs that Congress has passed. The Constitution gives Congress the power to control spending and borrowing. The debt limit or debt ceiling was introduced during World War I and was meant to give the Treasury greater flexibility by not having to have Congress approve every new issuance of debt every time the government needed to borrow to pay for things Congress had already voted for. As the national debt has grown, the Treasury has periodically bumped against this debt limit or debt ceiling. While votes to raise it are among the least popular things Congress does, the limit has been raised dozens of time, generally with little fanfare until 2011 when a conflict occurred between the Republican led House and President Obama who is a Democrat.
The Federal Budget: Where Does the Money Come From, and Where Does it Go
The Federal Government Dollar-Where It Comes From
The money that the Federal Government uses to pay its bills–its revenues or receipts–comes mostly from taxes. In the late 1990’s, revenues were greater than spending, and the Government was able to reduce the national debt with the difference between revenues and spending–that is, the surplus. The United States government has not had a surplus since.
Revenues come from a variety of sources. Individual income taxes and payroll taxes now account for four out of every five federal revenue dollars. Corporate income taxes contribute another 9 percent. Excise taxes, estate and gift taxes, customs duties, and miscellaneous receipts (earnings of the Federal Reserve System and various fees and charges) make up the balance. The composition of tax revenue has changed markedly over the past half century, with payroll taxes contributing an increasing, and corporate income and excise taxes a decreasing, share of the total, but the share provided by individual income taxes has remained roughly constant.
In fiscal year 2016, the federal government spent $3.9 trillion on the services it provides, such as national defense, health care programs like Medicare and Medicaid, Social Security benefits for the elderly and disabled, and investments in infrastructure and education, in addition to interest on the debt. Federal revenues financed over $3.3 trillion of that $3.7 trillion. Borrowing financed the remaining amount ($585 billion); future taxpayers will ultimately pay this deficit.
The three main sources of federal tax revenue are individual income taxes, payroll taxes, and corporate income taxes; other sources of tax revenue include excise taxes, the estate tax, and other taxes and fees.
Almost half of all federal revenue (47 percent) comes from individual income taxes. The income tax is generally progressive: higher-income households pay a larger share of their income in income taxes than lower-income households do.
Another 34 percent of revenue comes from payroll taxes, which are assessed on the wage or salary paychecks of almost all workers and used to fund Social Security, Medicare Hospital Insurance, and unemployment insurance. By law, employers and employees split the cost of payroll taxes, but research has shown that employers pass their portion of the cost on to workers in the form of lower wages.
Corporate income taxes make up about 9 percent of federal revenue, with the remaining 10 percent coming from excise taxes, estate taxes, and other taxes. Excise taxes are collected on the sale of certain goods (e.g., fuel, alcohol, and tobacco); they are intended to raise revenue and, in some cases, discourage consumption of the taxed product. These made up about 3 percent of federal receipts in 2016. Revenue from the corporate income tax fell from between 5 and 6 percent of GDP in the early 1950s to 1.7 percent of GDP in 2014.
Changes in the shares of the various taxes in total federal revenue reflect these historical shifts. The individual income tax has consistently provided nearly half of total federal revenue since 1950, while other revenue sources have waxed and waned. Excise taxes brought in 19 percent of total revenue in 1950 but only about 3 percent in recent years. The share of revenue coming from the corporate income tax dropped from about one-third in the early 1950s to less than one-sixth in 2016. In contrast, payroll taxes provided one-third of revenue in 2016, compared with just one-tenth in the early 1950s.
In recent years the Federal Government has been spending more money than it has taken in. Below is a list of where the money gets spent.
As shown in the graph below, about three-fifths of federal expenditures went to three areas, each of which comprised about one-fifth of the budget:
In fiscal year 2016, the federal government spent $3.9 trillion, amounting to 21 percent of the nation’s gross domestic product (GDP). Of that $3.9 trillion, over $3.3 trillion was financed by federal revenues. The remaining amount ($585 billion) was financed by borrowing. As the chart below shows, three major areas of spending each make up about one-fifth of the budget:
Social Security: Last year, 24 percent of the budget, or $916 billion, paid for Social Security, which provided monthly retirement benefits averaging $1,360 to 41 million retired workers in December 2016. Social Security also provided benefits to 3 million spouses and children of retired workers, 6. million surviving children and spouses of deceased workers, and 10.6 million disabled workers and their eligible dependents in December 2016.
Medicare, Medicaid, CHIP, and marketplace subsidies: Four health insurance programs — Medicare, Medicaid, the Children’s Health Insurance Program (CHIP), and Affordable Care Act (ACA) marketplace subsidies — together accounted for 26 percent of the budget in 2016, or $1 trillion. Nearly three-fifths of this amount, or $594 billion, went to Medicare, which provides health coverage to around 57 million people who are over age 65 or have disabilities. The rest of this category funds Medicaid, CHIP, and ACA subsidy and exchange costs. In a typical month, Medicaid and CHIP provide health care or long-term care to about 74 million low-income children, parents, elderly people, and people with disabilities. (Both Medicaid and CHIP require matching payments from the states.) In 2015, 9 million of the 11 million people enrolled in health insurance exchanges received ACA subsidies, at an estimated cost of about $31 billion.
Defense and international security assistance: Another 16 percent of the budget, or $615 billion, paid for defense and security-related international activities. The bulk of the spending in this category reflects the underlying costs of the Defense Department. The total also includes the cost of supporting operations in Afghanistan and other related activities, described as Overseas Contingency Operations in the budget, funding for which totaled $74 billion in 2016.
Two other categories together account for another fifth of federal spending:
Safety net programs: About 9 percent of the federal budget in 2016, or $366 billion, supported programs that provide aid (other than health insurance or Social Security benefits) to individuals and families facing hardship. Spending on safety net programs declined in both nominal and real terms between 2015 and 2016 as the economy continued to improve. These programs include: the refundable portions of the Earned Income Tax Credit and Child Tax Credit, which assist low- and moderate-income working families; programs that provide cash payments to eligible individuals or households, including Supplemental Security Income for the elderly or disabled poor and unemployment insurance; various forms of in-kind assistance for low-income people, including SNAP (food stamps), school meals, low-income housing assistance, child care assistance, and help meeting home energy bills; and various other programs such as those that aid abused and neglected children. Such programs keep millions of people out of poverty each year. A CBPP analysis using Census’ Supplemental Poverty Measure shows that government safety net programs kept some 36 million people out of poverty in calendar year 2016. Without any government income assistance, either from safety net programs or other income supports like Social Security, the poverty rate would have been 25.3 percent in 2016, nearly double the actual 14 percent. And these programs reduced the depth of poverty for millions more, even when not bringing them above the poverty line.
Interest on the national debt: The federal government must make regular interest payments on the money it borrowed to finance past deficits — that is, on the national debt held by the public, which reached $14 trillion by the end of fiscal year 2016. In 2016, these interest payments claimed $240 billion, or about 6 percent of the budget.
As the chart shows, the remaining fifth of federal spending supports a variety of other public services. These include providing health care and other benefits to veterans and retirement benefits to retired federal employees, assuring safe food and drugs, protecting the environment, and investing in education, scientific and medical research, and basic infrastructure such as roads, bridges, and airports. A very small slice — less than 1 percent of the budget — goes to non-security programs that operate internationally, including programs providing humanitarian aid.
While critics often decry “government spending,” it is important to look beyond the rhetoric and determine whether the actual public services that government provides are valuable. To the extent that such services are worth paying for, the only way to do so is ultimately with tax revenue. Consequently, when thinking about the costs that taxes impose, it is essential to balance those costs against the benefits the nation receives from public services.
Governments have different priorities in different years. Sometimes the government is interested in stimulating growth, other times it is interested in reducing spending. These priorities mean that there will be times when the government operates with a deficit or a surplus. A federal deficit occurs whenever the government spends more than it collects in taxes. Federal deficits occur within the government’s annual budget. The federal government ran a deficit each year from 1970 – 1997. The national debt, on the other hand, represents the accumulation of each year’s budget deficit. If the government has a surplus in a year, the surplus could be used to pay down the national debt. To cover the difference in spending more than the government takes in, it borrows the difference from investors in government securities, in the form of Treasury bills, notes, bonds, and certificates. The total amount owed by the federal government to owners of government securities represents our national debt.
The National Debt
Our national debt is now receiving more attention than it did during the late 1990’s. Not only is there disagreement on the size of the national debt, but also on what to do with it, and if we should even worry about it. Under President George W. Bush’s Administration, the national debt increased because of a recession, the war on terrorism, and tax cuts. Currently, under the Obama administration, the debt has increased because of the financial crisis, bank bailouts, and a continuation of the wars in Iraq and Afghanistan. The information below should help in better understanding our nation’s national debt.
Reasons to Worry About the National Debt
Some people worry about our national debt. They believe that if we keep overspending we will eventually go broke. They also believe we are passing our debt on to our children. The huge interest payments on the debt means that future generations will pay more of their tax dollar to the government’s creditors, leaving less for other needed programs such as building roads, health care, or education. Many people also worry about the crowding out effect. The crowding out effect states that the government takes out money from the economy that could otherwise be used by private investors, to service the national debt. In a sense, the government and private industry are competing for the same pool of money to use. If there is less money for business to use, then this might mean less business investment and less consumer consumption. To sum up, government borrowing tends to raise interest rates, which in turn, discourages investment. Finally, there is growing concern that we have become increasingly dependent of foreign savers, particularly the Chinese, to finance the debt.
Reasons to Not Worry About the National Debt
There are other people in our society who believe that concern over our national debt is overstated. They believe the government can’t go bankrupt. The government can “roll over” the debt. This means that when a $ 1 million bond comes due, the government refinances the debt with a new $ 1 million dollar bond. In a sense, the debt can be rolled over forever. Another point made, is that the debt, as a percentage of gross domestic product, currently represents a lower figure (100%) than it did after World War II ( 122%). Furthermore, they would add, most of the debt is owed internally. We owe it ” to ourselves”. Only 32.5% of the debt is foreign owned. Foreign investment in the United States supplements domestic saving. Borrowing from abroad can prevent the higher interest rates that would exist if the U.S. Treasury relied only on domestic savers to purchase federal government securities. Finally, many economists, particularly Keynesians, believe the crowding out effect has minimal influence. They believe building highways, dams, etc… will offset any decline in private investment. They also believe that such spending would boost consumption and increase aggregate demand.
Will The United States Ever Be Able to Balance the Budget?
There are only a few options available to reducing the deficit and balancing the budget. One, would be to reduce spending. This option is often politically difficult to do, since there are many interest groups donating to political campaigns to ensure that the money keeps coming. Second, the government could raise taxes. This is also politically difficult to do. Remember when the first President Bush said, “read my lips, no new taxes” and then instituted new taxes? The third option would be to promote economic policies that would create a high rate of economic growth. If the spending rate were below the growth rate, then the deficit would begin shrinking. Lastly, a combination of all these options would help. There are many Americans, politicians included, who believe that our country needs a balanced budget amendment. Such an amendment would force the president and Congress to submit and pass balanced budgets.
International Comparison of National Debt
The discussion in this unit has focused primarily on the national debt of the United States. As you can see, there is a debate as to how harmful that debt is. How do we compare to other industrial countries? The chart below compares United States debt, as a percentage of GDP, to other industrialized nations. Click here to view a table that shows international debt by country around the world.
Are there countries that don’t have annual deficits and don’t have an accumulated debt? Click here to visit a webpage that looks at which countries have surpluses and which countries have debts.
Connection Between Unemployment and Debt
When an economy experiences high unemployment, it will almost certainly also experience an increase in the debt.
If unemployment is high, deficit/debt as a percent of GDP is high. If we reduce unemployment, the deficit/debt shrinks.
When workers are unemployed, they do not have paychecks. No paycheck means there can not be local, state, and federal taxes deducted to pay for services. This forces governments to either cut services or to increase borrowing to pay for deficit spending. The best way to reduce deficits and debt is for an economy to move towards full employment.
The above chart from the St. Louis Federal Reserve shows the deficit as a percentage of GDP (red line) vs. the unemployment rate (blue line); for 60 years the pattern has held. When unemployment drops, the deficit as a percentage of GDP drops. When unemployment rises, the deficit rises. Members of both political parties seem to ignore this relationship when discussing ways to reduce the deficit/debt.
How Do World Government’s Respond to High Debt Levels?
Governments and financial centers around the world have responded to the latest economic crisis which has produced large deficits by demanding that austerity measures be implemented. The policies of austerity are not unique to the U.S. They are being enacted internationally. In Europe they have been aggressively put into play since 2009.
What are the policies of austerity? They involve the cutting of public investment and services such as education, health care, and retirement insurance. In addition they also include the privatizing of existing government assets. Public employees suffer wage freezes or cuts and mass layoffs as part of austerity measures. Labor laws are revised to empower employers at the expense of employees’ job security, wages, benefits, and voice on the job. And austerity also involves increased taxes and fees on working class people. Workers don’t appreciate the increased taxes, cutting of social programs and rising unemployment, so they have taken to the streets in protest.
Austerity is sold as the only available means of reducing the debt. However, there is plenty of money to take care of these financial imbalances. It is in the pockets of the wealthy and big business elites whose think tanks and politicians are, not coincidentally, the architects of austerity. They want nations’ economies to be run more like the corporations and banks, prioritizing that their shareholders get paid first and foremost at the expense of everyone else.
How Do We Finance The Debt
The money is borrowed from buyers of Treasury securities — which are basically a big batch of IOUs that are auctioned off every three months. As the auction date approaches, the Treasury figures out how much it will need to pay off old debt and cover the government’s latest round of overspending.
When the auction day comes, buyers submit bids in the form of the interest rate they’re willing to accept. You can choose to make a competitive bid (you ask for a specific rate) or a non-competitive bid (you agree to accept the average rate of other winning bids.) When all the bids are in, the Treasury starts at the bottom, taking the lowest bids until it has collected enough money to cover that round of borrowing. Once issued at auction, Treasury securities enjoy a healthy second life when they’re traded in the so-called “secondary market” (aka the “bond market.”) The prices of bonds bought on the open market go up and down as the market reacts to changes in demand and news about the economic outlook like inflation. But no matter what you pay for a bond, if you hold it until it matures, the government has to pay back the full amount that was borrowed when the debt was first auctioned and issued.
Who Owns U.S. Debt?
The money flows in from all over the place: from individual investors and corporations, pension funds and governments, both in the U.S. and around the world. Basically, anyone with a large amount of cash looking for a safe place to put it is a good candidate for holding U.S. Treasury debt.
So just who are these lenders? Much of the debt is owned internally. U.S. entities own 67.5% of all debt issued by the U.S. federal government. Ranking the major U.S. entities from low to high, we find that: The U.S. government’s military retirement fund owns 2.4% of the national debt, the U.S. government’s civilian employee retirement fund accounts for another 5.6% of the nation’s debt, the U.S. Federal Reserve has racked up holdings equal to 10.8% of the total U.S. national debt, the U.S. Social Security Trust Fund claims 16.7%, and U.S. individuals and institutions, which includes state and local governments; individual investors, including brokers; public and private pension funds, mutual funds, holders of US savings bonds, insurance companies, and banks and credit unions, own 30.4% of the nation’s debt. Just as you may prefer to keep your Individual Retirement Account in the safe Treasury bonds, the folks who manage the Social Security Trust Fund are looking for a secure investment, too.
Foreign entities own 32.5% of all U.S. government-issued debt. The graph below shows the countries which hold U.S. debt.
An Alternative View of Debt
Is there a non-textbook way of viewing debt? Here is an alternate and more radical way of viewing debt. Stated plainly, debt is created when a powerful group of people impose scarcity upon another group of people who have been conquered. Those with money force those with little or no money into debt. This is one of the root causes of poverty. Debt is the destabilizing force of unequal societies that breeds civil unrest and revolution. Historically, debt created the need for Hebrew kings to introduce the Jubilee. They knew that a revolution might cause the people to rise up and clear their own debts, while also uprooting the monarchy from power. In order to preserve their power base, they would routinely erase the debt and start again.
So who is creating debt today? The financial sector. How do they do it? The truth is that bankers are the source of all money in the United States. Either the Federal Reserve bankers create it, or individual bankers create it through the mechanism of fractional reserve banking. In both cases, it is bankers that are creating the money. Any money that is created comes into existence as debt. Either the U.S. government goes into more debt when it gets more dollars from the Federal Reserve or individual Americans go into more debt when they take out loans from individual banks.
Links About Debts and Deficits
8. Can We Reduce the Federal Deficit If Federal Politicians Own Stock in the Companies They Oversee? In Other Words, Should Senators on the Senate Foreign Relations Committee Own Stock in Companies That Receive Pentagon Contracts?