Hey, Big Spender! The Federal Budget: The Government Share of the Economy

The Government Share of the Economy

In the U.S. economy, total government spending at all levels represents about 28 percent of GDP. Private spending makes up the other 72 percent. That 28 percent figure breaks down as shown in Figure 12.1.

As the figure shows, of the 28 percent of GDP that government spending represents, direct federal programs (programs administered by the federal government) represents 16 percent while state and local spending represents the other 12 percent. Of that 12 percent, about 9 percent is raised by the states and local jurisdictions, and about 2 percent comes from federal government grants. The two numbers—9 and 2 don't add up to 12 because of rounding differences in the government data. That reminds me of a quote attributed to Senator Everett Dirksen: “A billion here, a billion there, and pretty soon you're talking about real money.”

The government share of GDP is substantially larger in other industrialized economies. In the 1990s in Italy, France, and Germany, government expenditures accounted for 45 to 55 percent of GDP, and in the United Kingdom, 40 to 45 percent.

Budgeting Billions

As is the case in most financial situations, understanding the budget is the key to understanding the government's finances. Each year the federal government undergoes a budgeting process in which the White House Office of Management and Budget (OMB) develops a budget that the president proposes to Congress.

Congress reviews this proposed budget and goes through its own budget process. In that process, Congress passes a budget resolution with targets, expressed in dollars, for total spending and revenues and for the surplus or deficit. Congress also allocates total spending between discretionary spending and mandatory spending. Finally, Congress approves its spending and revenue bills, which then are turned over to the president to be signed.

The distinction between discretionary and mandatory spending is key. Discretionary spending accounts for only one-third of all federal spending. This amount is what the president and Congress must decide to spend in the next year, which they do by means of 13 annual appropriations bills, which Congress passes and the president signs. These bills allocate money to activities such as the FBI, Coast Guard, housing, education, space programs, highways, defense, and foreign aid.

Mandatory spending accounts for two-thirds of federal spending and is authorized by permanent laws, not by the 13 annual appropriations bills. These include entitlements, such as Social Security, Medicare, veterans' benefits, and Food Stamps. They are called entitlements because citizens are entitled to the benefits, based upon their age, income, military service, or other criteria. Mandatory spending also includes interest on the national debt.

Mandatory spending could be changed by changing the laws that govern the entitlements. But otherwise, that money has to be spent according to the law. Discretionary spending requires the Congress and president to appropriate the money to fund it. As a practical matter, changing the laws regarding entitlements is politically quite difficult, and annual appropriations, especially for activities such as defense and education, are not exactly optional in the true sense of the term. The allocation of discretionary spending may be at issue—foreign aid, for example, is usually controversial—but huge sums for discretionary spending always wind up in the budget.

The federal government's fiscal year begins on October 1. Fiscal year 2004, for instance, begins on October 1, 2003 and ends on September 30, 2004. During the fiscal year, the relevant government agencies spend and disburse the budgeted money. As they do, the agencies, OMB, congressional committees, and General Accounting Office (GAO), all monitor the amounts spent and the effectiveness of the programs being funded. (The GAO is the main auditing department of Congress.)

Where It Comes From

The federal budget is managed like most household and business budgets: money comes in from various sources of revenue, and money goes out to pay various expenses. If revenue does not cover the expenses in a given period, the household or business borrows the money to meet the expenses.

Increasing levels of debt usually indicate a need for a course of action other than continued borrowing. One is raising revenues. The householder can take a second job or find a higher paying one. The business can raise its prices or push into new markets. The government can raise revenues in various ways, such as raising tariffs on imports. But the only meaningful way for the federal government to increase revenue is to increase taxes.

Economically, increasing taxes can make sense, as we'll see in Fiscal Policy and Economic Growth. Politically, it can mean professional suicide for the president and legislators. It's the old story: Everyone wants to go to heaven, but nobody wants to die. People want government services, but they don't want to pay for them.

Income taxes on individuals account for about 48 percent of total federal revenue. That percentage may sound low to you, but payroll taxes, which are paid by individuals and businesses, account for another 33 percent. Payroll taxes include taxes for Social Security, Medicare, and unemployment insurance. That brings total revenue from income and payroll taxes to about 80 percent.

Corporate income taxes contribute about 10 percent of total revenue. The other 10 percent comes from excise taxes, estate and gift taxes, customs duties, and miscellaneous revenues, such as fines.

Figure 12.2 shows the breakdown of federal revenues by source.

As of this writing, the federal government must raise over $2 trillion a year, every year. That's tough to do when you're cutting taxes. So, can the government cut spending?

In theory, yes. Since 1980, the beginning of President Ronald Reagan's first term, presidents and legislators have been promising to reduce taxes and make the federal government smaller. Attempts to reduce taxes have occasionally succeeded: President Reagan reduced taxes in the early 1980s—and a decade of higher deficits ensued because no one remembered to reduce federal expenditures. George W. Bush may succeed in locking in long-term tax cuts, but don't bet the ranch on a reduction in federal expenditures.

A closer look at where the money goes will reveal why.

Where It Goes

Recall that two-thirds of the federal budget is spent on entitlements. Of these mandatory expenditures, the largest one is for Social Security, which accounts for about 23 percent of total federal expenditures. The next largest mandatory expenditure is for Medicare (12 percent) and Medicaid (7 percent), which add up to 19 percent of total federal expenditures. So about 42 percent of the federal budget is going to Social Security and subsidized health care. Other means-tested entitlements and mandatory payments and net interest on the federal debt add up to 23 percent. So, the 42 percent for Social Security and subsidized health care and the 23 percent for other entitlements and net interest equal 65 percent, or about two-thirds of total expenditures.

Figure 12.3 shows the breakdown of federal expenditures.

(Source: Office of Management and Budget)

Here's why it's so difficult to reduce federal expenditures. The so-called entitlements are mainly either agreements between the government and certain citizens, or forms of assistance for people who need health care, in the case of Medicare and Medicaid, or food, in the case of Food Stamps. These are difficult areas in which to reduce spending. That's especially true of Social Security.

How discretionary is discretionary spending? The United States cannot decide to spend nothing on defense for a year or two, or even cut it by $10 or $20 billion (especially now that the nation faces the threat of terrorism). As for nondefense spending, programs such as government financed research in science and technology require ongoing support or they will fall apart. If they are already in place and achieving progress, they stand a good chance of receiving continued funding. The same goes for programs that support education, transportation, and law enforcement.

Is there really much spending that can be cut? The average citizen thinks so, and the average politician says so, but with an annual budget that runs to thousands of pages and a constituency for every program, elected officials seem unable to find much to cut. A look at the largest program, Social Security, provides some insight regarding the reasons.