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Social Security, and the U.S. Federal Budget

SOCIAL SECURITY, AND THE U.S. FEDERAL BUDGET

The Social Security Old-Age, Survivors and Disability Insurance (OASDI) programs play an important role on both the individual level and in the overall United States economy. The most visible influence of the programs is as a source of income when workers retire, or in instances of death or disability. Less visible, but equally important, are its effects on the national economy. Social Security affects economic output primarily through its influence on individuals decisions on how much to work, when to retire, and how much to save. As the largest function in government, based on expenditures, Social Security also contributes to government saving and spending.

This entry first describes how the OASDI programs are financed and how they relate to the federal budget. Next, the entry examines determinants of economic output and the influence Social Security exerts on two of those determinants: labor supply and national saving. Finally, it discusses the role of economic growth in meeting the needs of society and two options economists and policymakers have considered for using Social Security to increase national saving, and thereby increase economic output.

Social Securitys financing

Nearly 90 percent of the funding for the OASDI programs benefits and administration comes from a dedicated tax on earnings, called the Federal Insurance Contributions Act (FICA) tax. Employers and employees each contribute 6.2 percent of their gross wages up to a certain annual limit that is increased yearly to reflect wage growth ($84,900 in the year 2002). Self-employed persons pay both the employer and employee portions of the FICA tax. The remainder of program funding comes from taxation of Social Security benefits and interest from the investment of surplus revenues.

The government operates Social Security on a pay-as-you-go basis, meaning Social Security uses most of its annual revenues to pay current beneficiaries. Aside from benefit payments, the programs use approximately 1 percent of FICA taxes to pay for operational expenses. Since the mid-1980s, Social Securitys revenues have exceeded its expenditures. The Treasury Department credits this excess revenue to the OASDI Trust Funds.

In 1999, Social Security revenues exceeded expenditures by approximately $134 billion (Trustees Report, Table II.F12). The Trust Funds invest excess revenues in special-issue Treasury bonds, which earn interest. The interest rate paid on the special-issue Treasury bonds equals the average yield on marketable Treasury bonds and other interest-bearing obligations of the United States that are not expected to be redeemed in the near future. In 1999, the Trust Funds earned approximately $56 billion in interest from their investments, which is equal to an effective interest rate of about 7 percent.

The federal governments use of Social Securitys excess revenues is similar to how a bank uses money that is deposited into a bank account. The bank records the deposit on an account statement and pays the account holder interest for the banks right to borrow those dollars, much like the Treasury records the surplus FICA taxes to the Social Security trust funds and pays interest on the borrowed funds. Treasury then uses the excess Social Security revenue to fund or reduce other cash needs. The Treasury bonds issued to the Social Security Trust Funds represent an obligation of the government to pay Social Security the amount invested, plus interest.

Social Securitys treatment within the federal budget

Social Securitys receipts and expenditures are part of government activities; therefore, they are viewed as part of the entire federal budget. Social Security receipts equal approximately 26 percent of all federal receipts and about 23 percent of all federal expenditures.

Even though Social Security is part of the overall (also known as unified ) federal budget, it receives special treatment within the federal budgeting process because of its size, its importance, and its funding source (the dedicated payroll tax). Special rules apply when Congress considers and acts on changes to Social Security financing and benefits. Social Security is generally exempt from budget process rules. This special treatment means Social Security is considered off-budget.

In addition to off-budget treatment, Social Security is part of a special class of programs for which Congress does not make a decision on the annual funding level for benefit payments. The number of people entitled to a benefit and the size of those benefits determines the funding level. However, Congress makes annual decisions on how much the Social Security Administration may spend on running the programs. Also, Congress may change the program rules, thereby altering the number of people entitled or the size of benefits.

Although Social Security is officially off-budget, documents from the Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) continue to show the unified budget (which contains all federal receipts and expenditures, including Social Security), as well as budget totals excluding Social Security. These entities emphasize unified budget totals, because persons interested in the impact of government on the economy need to know the total income, expenditures, and borrowing of the government.

Social Securitys effect on the national economy

In fiscal year 1999, Social Security received payroll taxes and taxes on Social Security benefits equal to roughly 5 percent of the gross domestic product (GDP) and paid out benefits equal to approximately 4 percent of the GDP. Social Security influences economic output through these transactions.

Economic output is commonly measured using the GDP. The GDP is the market value of final goods and services annually produced within a nation over a certain period of time. Labor supply, capital investment, natural resources, and technology all determine economic output. Social Security is thought to primarily influence the first two categories: labor supply and capital investment.

The effect of Social Security on labor supply. Both Social Security taxes and benefits can influence an individuals decisions on whether to work and how much to work. The effect of the Social Security payroll tax is complex; it may either increase or decrease the incentive to work, depending on how much an individual wants to spend and save and how the individual views the payroll tax. Economic theories indicate Social Security taxes create two opposing effects, known as the income effect and the substitution effect. Social Security benefits, on the other hand, are believed to reduce the incentive to work based on their income effect.

The income effect describes how changes in real wages (the purchasing power of wages) or wealth influence how much a person may consume. Leisure time is something that individuals can consume, like clothing, cars, and other goods. Decreases in real wages or wealth decrease the amount of things, including leisure, that a person may consume. Likewise, increases in wages or wealth increase the amount of goods, including leisure, that a person may consume.

The substitution effect describes how changes in the price of something a person consumes influences the composition of the entire collection of things that person may consume. Changes in real wages influence the opportunity cost of leisure. The opportunity cost of leisure is essentially equal to wages lost by not working during leisure time. When leisure becomes less expensive (i.e., wages decrease), individuals will substitute less work for more leisure and will reduce the amount of labor they supply to the economy.

If workers view the Social Security tax as only a tax, and not as a contribution toward retirement, then the income effect indicates workers would increase the amount they work in response to the perceived reduction in real wages. If workers view the tax as a retirement contribution that provides wealth in the form of earned Social Security benefits, then the income effect indicates workers may decrease the amount of labor they supply. The Social Security tax could also decrease labor supply through the substitution effect, because the reduced real wage reduces the opportunity cost of leisure.

The strength of the effect of Social Security benefits on labor supply depends on both the availability of benefits and the size of benefits. The availability of early retirement Social Security benefits at age sixty-two and regular retirement benefits at age sixty-five may reduce the supply of labor as a result of the income effect. Social Security retirement benefits provide a nonwork source of income, reducing the amount of work needed to achieve a desired level of income.

There is evidence indicating that labor force participation rates of persons around retirement age dropped when retirement benefits became available at age sixty-two in 1956 for women and in 1961 for men. Approximately half of all workers currently apply for Social Security benefits when they attain age sixty-two. Evidence also suggests that availability of benefits at the normal retirement age, which is gradually increasing from age sixty-five to age sixty-seven, induces workers to leave the workforce. Currently, age sixty-five is the second most common age for retirement, after age sixty-two.

Several Social Security program provisions affect the size of an individuals monthly benefit. The workers earnings history is the primary determinant of the size of retirement benefits. However, the program reduces a persons monthly retirement benefits when he or she retires before the normal retirement age, which is age sixty-five for workers who attained age sixty-two before the year 2000. The program increases a persons monthly retirement benefits when he or she retires after the normal retirement age. Also, the program reduces a persons current monthly benefits if he or she retired early and has earnings exceeding a certain threshold ($11,280 in 2002) that is raised annually in line with national wage increases. These adjustments are designed to be neutral over an average lifetime, but some persons may alter their labor supply because of them.

There are two programmatic changes underway that may alter labor force participation among older Americans. First, the normal retirement age is increasing from sixty-five, beginning with people born in 1938, until it reaches sixty-seven for people born after 1959. As a result, persons taking early retirement benefits will receive an even greater decrease in annual benefits, compared to persons who retire at the normal retirement age. This may encourage work among persons between the earliest retirement age and the normal retirement age. Second, the delayed retirement credit is increasing from 6 percent per year of delay (for persons age sixty-two in years 19971998) to 8 percent (for persons age sixty-two in years 2005 and later).

Most economists agree that Social Security benefits have decreased the labor supply of older workers. Hurd and Boskin show that increases in real Social Security benefits in the early 1970s explain the majority of reduced labor force participation among married men aged fifty-eight to sixty-seven in 1969 through 1973. Hausman and Wise found a smaller effectthat the increase in Social Security benefits accounted for possibly one-third of the decrease in labor force participation of men age sixty and older between 1969 and 1975. Others have argued that factors unrelated to Social Security, such as health status, receipt of a private pension, availability of health insurance, and the retirement status of a spouse have a greater influence on the labor supply of older workers.

Social Security did not initiate the decline in labor force participation rates for older workers. According to a study by Dora Costa, 70 percent of the decline in the labor force participation rates of U.S. men age sixty-five or older occurred before 1960, when benefits were lower and fewer types of employment were covered under Social Security.

The effect of Social Security on national saving. Social Security taxes and benefits influence capital investment, as well as labor supply. Social Security influences capital investment through its effects on private (includes personal and business) saving and government saving. Together, private and government saving are known as national saving.

The ability of a country to invest in capital is linked to the amount of national saving. National saving is the difference between what the U.S. economy produces and what it consumes and represents funds that are available for capital investment. Capital comprises items like buildings, computers, and machines. To the extent saved funds are invested in capital, they can increase economic output.

Social Security taxes and benefits have a direct effect on government saving. Government saving equals revenues (tax receipts) minus the purchase of goods and services, transfer payments, and interest payments to the public on government debt. To the extent that Social Security receipts equal the sum of benefits paid and administrative costs, it has no net effect on government saving.

However, the Social Security Trust Funds are currently building up reserves. To the extent Social Security tax receipts exceed benefits and administrative costs, they can increase government saving or reduce government dissaving. In times when the non-Social Security portion of the federal budget runs deficits, Social Security surpluses reduce the governments need to borrow, thereby reducing government dis-saving. In times of unified budget surpluses, the government uses the funds to buy back publicly held debt, making additional funds available for private saving and investment.

As Table 1 shows, Social Security has decreased government dis-saving or increased government saving since the mid-1980s. However, in the mid-1970s and early 1980s, the Social Security Trust Funds paid out more in benefits than they received in income, increasing government dis-saving. It is important to remember that the government does not make spending and taxing decisions regarding Social Security and the rest of the federal budget independently of each other, and these decisions influence each other. For example, if the existence of the Social Security tax kept the government from increasing other taxes, then Social Securitys contribution to government saving is larger and the rest of the budgets contribution is smaller than it would be otherwise.

The Social Security Trust Funds are not expected to maintain a surplus indefinitely. By the year 2015, benefits will exceed Social Security payroll tax revenues according to current law actuarial estimates. At that point, Social Security will decrease government saving. This does not mean that the government will be unable to pay Social Security benefits in 2015. However, the Trust Funds will use interest on its investments to help pay benefits. After 2025, actuarial estimates indicate the Trust Funds will begin to redeem their investments. Redeeming the Trust Fund investments will reduce budget surpluses or increase any deficits.

The effect of Social Security on personal saving is less clear. Many factors contribute to a persons consumption and saving decisions: income levels, the desire to bequeath assets to future generations, concern about unplanned events (disability, unemployment, health crises, etc.), the timing of retirement, and awareness of the amount of savings needed to generate a given level of income at retirement.

Various theoretical arguments support the belief that Social Security decreases personal saving. Social Security could reduce the need for personal saving, since it reduces the amount of spendable wealth needed to produce a specific level of income. Alternatively, Social Security may raise awareness of the need to plan for retirement or encourage workers to retire early, encouraging people to save more than they would otherwise. Finally, some theoretical arguments indicate Social Security has a roughly neutral effect on personal saving. Some persons may increase bequests to their children, knowing that the payroll tax paid by their working children funds their Social Security benefits in retirement. It may also have no effect if workers choose to increase nonpension saving by an amount roughly equal to any reduced saving for retirement.

Economists have not completely modeled all the factors that contribute to decision-making; therefore, they rely on a combination of theory and empirical evidence to try to determine Social Securitys effect on personal saving. Most current research shows Social Security reduces personal saving to some degree. For example, Feldstein and Diamond and Hausman found that Social Security has a negative effect on saving. However, a few studies show Social Security may not decrease overall personal saving. For example, Gullason, Kolluri, and Panik found that Social Security has no significant effect on overall personal wealth, but decreases pension wealth.

We do not know the exact degree to which Social Security influences national saving (combined government, personal, and business saving). If Social Security decreases national saving, then economic output/national income is less than it could be in the absence of Social Security. If the less likely scenario is trueif Social Security increases national savingthen economic output/national income is higher than it would be in the absence of Social Security.

Social Security as a tool in promoting economic growth

Economic growth is critical to a nations ability to improve standards of living over time, because citizens are able to purchase more goods and services. The desirability of increasing available goods and services will be more important as the baby boom generation starts retiring in about 2010. For example, expenditures for OASDI programs are estimated to increase from approximately 4 percent of GDP in 1999 to nearly 7 percent of GDP by 2075 (U.S. Social Security Administration). Economic growth will not entirely resolve questions about how large the Social Security programs or other federal programs ought to be in relation to the federal budget and the economy. However, economic growth can help future generations by providing a larger income base to use in meeting societys needs.

Some economists and policymakers believe the Social Security programs could be used to increase national saving and capital investment, and consequently promote economic growth. Some propose greater prefunding of Old-Age benefits (the program is currently a pay-as-yougo system), either through individual retirement accounts or larger Trust Fund reserves. Others propose reducing the amount of publicly held debt (meaning government bonds held by individuals or nongovernmental institutions) by running overall federal budget surpluses.

Prefunding Old-Age benefits does not automatically lead to increased national saving. Prefunding would only increase national saving to the extent that saving in one form is not offset by reductions in other types of saving. For example, if individuals offset other types of saving in direct relation to increases in their individual accounts, the net effect may be neutral. Also, if the government borrows from the public in order to fund the accounts, national saving will not change. In other words, decreases in government saving would offset increases in private saving. Likewise, increasing reserves held by the Trust Funds will not automatically lead to increased national saving if the government reduces taxes or increases spending in direct relation to resources held by the Trust Funds.

Reducing publicly held debt could potentially increase economic output by increasing national saving. Persons and institutions selling their Treasury bonds back to the government would potentially seek other ways to use their money. To the extent the private sector is more likely to use the funds for capital investment than the government, the funds would increase productivity and economic output.

Reducing publicly held debt would also reduce the governments expenditures on interest payments. In fiscal year 1999, the government spent approximately fourteen cents of every federal dollar on interest payments. To the extent the governments income increases by taxing the larger income base and the governments expenditures on interest payments decrease, government saving could increase (assuming no changes in tax rates or expenditures). These changes would help create room in the federal budget for the increased Social Security costs of baby-boomers and the generations that follow.

Summary

Social Security is an important part of the federal budget and influences the national economy. Although Social Security is considered separately during the budget process, the program contributes to the governments overall effect on the economy.

Social Security programs influence economic growth through their effects on labor supply and national saving. The exact degree of their effects is unclear. Economists generally agree that Social Security benefits reduce the labor supply of older workers. The effect of Social Security taxes on overall labor supply is more ambiguous and depends upon the consumption preferences of individual workers and whether workers perceive the tax merely as a reduction in income or as an increase in wealth. Likewise, the effect of Social Security on national saving is not perfectly understood, although most economists agree it reduces private saving to some extent.

Although there is uncertainty about the exact effect of Social Security on national saving, some economists and policymakers believe it may be possible to use Social Security financing to improve economic growth, particularly if Social Security could be used to increase national saving. However, prefunding retirement benefits does not guarantee that increased saving in one sector of the economy will not be offset by decreased saving in another sector. Many economists and policymakers agree that paying down publicly held debt will help the economy and the government prepare for anticipated increases in expenditures resulting from the aging of the baby boom generation.

Jane L. Ross Sophia Wright Laura Haltzel

See also Social Security, Administration; Social Security, History and Operations; Social Security, Long-Term Financing and Reform.

BIBLIOGRAPHY

Burkhauser, R. V., and Turner, J. A. A Time-Series Analysis on Social Security and Its Effect on Market Work of Men at Younger Ages. Journal of Political Economy 4 (1978): 701714.

Costa, D. Pensions and Retirement: Evidence from Union Army Veterans. Quarterly Journal of Economics 4 (1995): 297319.

Diamond, P. A., and Hausman, J. A. Individual Retirement and Savings Behavior. Journal of Public Economics 1/2 (1984): 81114.

Feldstein, M. S. Social Security and Private Saving: Reply. Journal of Political Economy 3 (1982): 630642.

Gullason, E. T.; Kolluri, B. R.; and Panik, M. J. Social Security and Household Wealth Accumulation: Refined Microeconomic Evidence. Review of Economics and Statistics 3 (1993): 548551.

Hausman, J. A., and Wise, D. A. Social Security, Health Status, and Retirement. In Pensions, Labor, and Individual Choice. Edited by David Wise. Chicago, Ill.: The University of Chicago Press, 1985. Pages 159191.

Hurd, M. D., and Boskin, M. J. The Effect of Social Security Retirement in the Early 1970s. Quarterly Journal of Economics 4 (1984): 767790.

Ippolito, R. A. Toward Explaining Early Retirement After 1970. Industrial and Labor Relations Review 5 (1990): 556569.

President of the United States. Economic Report of the President. Washington, D.C.: Government Printing Office, 2000.

U.S. Social Security Administration. The 2000 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds. Washington, D.C.: 2000.

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Budget, Federal

BUDGET, FEDERAL

BUDGET, FEDERAL. The federal budget, and the budgetary process, is a social contract between a people and its government. Despite its complexity, it is a document that shows our societal preferences (for example, guns versus butter) and demonstrates that we do not live in a consensus political economy—interest group and class politics are alive and well.

What Is the Budget?

According to Aaron Wildavsky, "The budget is a representation in monetary terms of government activity. If politics is regarded in part as conflict over whose preferences shall prevail in the determination of policy, then the budget records the outcomes of this struggle."

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 is one of many tools available to the government to accomplish its goals; in addition, there is the tax system, loans and loan guarantees, monetary policy, regulation, the courts, and government-sponsored enterprises such as the mortgage lender FNMA (Federal National Mortgage Association), or Fannie Mae.

The federal budget also works with state and local government budgets. Certain government obligations are exclusively federal, such as national defense. Most education and transportation funding comes from states. Fire and police departments are paid for at the local level. Income and payroll taxes provide most federal revenue. States rely on sales taxes, and many also levy an income tax. Local services are mostly funded from property taxes.

The budgetary process is massive and involves the president and the executive departments, the Congress, outside interest groups, and the courts. To take a snapshot from 1988, the federal budget spending equaled one-fourth of national income, involved over 5 million civilian and military personnel, and was tracked in nearly 2,000 separate accounts. Even in a society that extols the virtue of free enterprise, the federal government is still the largest borrower, the largest spender, and the largest income receiver in the economy.

Key Terms and Concepts

Authorization, appropriation, and outlays. Before any federal entity can spend money, it needs both authorization—an approved guideline that explains the goals of a program and sets a spending limit—and appropriation. Appropriation is a separate legislative act that allows a program or department to make a spending commitment, such as hiring an employee or buying a jet fighter. Appropriations are not supposed to exceed budget authority. Finally, the money spent is budget outlay. In any given year, there is a significant amount of budget authority from prior years that obligates outlays in the current year.

Entitlements. A large portion of the budget is used to pay for obligations that do not require budget authority. The Social Security Act, for example, outlines who is eligible for a social security pension. The amount of money spent each year on this program, the outlay, does not depend

on budget authority or appropriations; it is driven by how many people are eligible under the current law. Other programs in this category include food stamps, Medicare, and veterans' pensions. Because of prior budget appropriations and formula-driven programs such as entitlements, as little as 25 to 30 percent of a given year's budget is discretionary.

Economic assumptions. Perhaps the most confusing part of any budget debate is predictions on the future performance of the economy. Both the president's Office of Management and Budget (OMB) and the Congressional Budget Office (CBO) make economic forecasts. Often they do not agree. Even a slight discrepancy in economic growth or inflation can result in very different pictures of the future budget.

Baselines. A baseline is an estimate of what a certain program at current service levels will cost into the future. For example, many federal programs are indexed to inflation. Government payments of medical care for elderly and low-income citizens depend on the number of people who are eligible and the increase in medical costs. If medical costs are rising and/or more people are eligible for government-paid care, then the future budget baseline will be higher than the current one. In budget terms, this is neither an increase nor a cut. A decision to cut or increase funding is applied to the new baseline. Like economic projections, baseline calculations also are a source of controversy.

Off budget. Not all federal spending is reflected in the federal budget. Sometimes a particular program is funded by a special tax and therefore is not part of the budget deliberation, and some items are taken off budget as an accounting trick.

Budget effort. Measuring the budget is more difficult than it might first appear. Different indicators tell contradictory stories. In 1962, for example, the federal budget was about $107 billion. In 1984 it was nearly$852 billion. On its face, this looks like a spectacular increase

in spending and the growth of government. The problem with this comparison is that it does not adjust for inflation (a dollar in 1962 was "worth" more than one in 1984) or for the growth in the economy, which is typically measured as gross national product (GNP) or gross domestic product (GDP). The federal budget in 1962 amounted to 18.8 percent of GDP; in 1984, it was 22.2 percent. This suggests a rather gradual increase in government spending.

Goals of the Federal Budget

Public finance professors Peggy and Richard Musgrave argue that the federal budget has three goals: (1) to provide social goods, (2) redistribute income, and (3) manage the economy. Social goods are the things that we as a community can enjoy but that the market does not provide—including national parks, battleships, and interstate highways. The budget also redistributes income. This may take the form of transfer payments—money to low-income citizens—and subsidizing services and products used by low-income people, such as housing, medical care, and food. Finally, the budget tries to cushion the swings in the business cycle. Since the Great Depression of the 1930s, the federal government has tried to manage the economy. The federal budget pursues this goal through automatic mechanisms and deliberate action. For example, the government automatically pumps buying power back into a community when workers are laid off through unemployment insurance payments to individuals. In addition, Congress may enact a fiscal stimulus package where the government tries to spend money with the goal of increasing economic demand and creating jobs.

The Budgetary Process

The revenue side of the budget is managed through periodic changes to the tax code. The appropriations side of the budget, however, is prepared annually to allow for regular reviews of policies and programs. 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 2002 ended on 30 September 2002).

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 president presents a budget to Congress in early February. Although the budget is a single document, it is funded through thirteen separate bills. The House of Representatives and the Senate, through their committees, analyze and debate the budget and usually pass the modified funding bills between April and mid-September. If there are differences between the House and Senate versions, the bills go to the conference committee. Once both houses pass the final versions, they send them to the president for a signature. The power of a presidential veto is great since a single party rarely has the two-thirds majority vote necessary for a veto override.

At the end of the year there are two types of audits. One attempts to make sure that the money was handled honestly—a check on possible graft and corruption. The other is a performance audit that analyzes the effectiveness of different programs in an effort to enhance program outcomes while minimizing costs. These outcomes are often measured as ratios or other numerical relationships of cost to services or product. For example, tax collecting agencies will monitor their performance as "cents to collect a dollar of taxes." This type of measurement has become increasingly important in recent years as the federal government moves in the direction of "performance based budgeting."

Tools for Achieving Compromise

Since claims always exceed available resources, the budget is an effort to negotiate multiple claims from competing interest groups, regions of the country, and economic classes. Even when there is broad agreement, for example, on the need for a fiscal stimulus package during the recession of 2001, there are disagreements over the specifics. To combat the recession, the Republicans wanted to create jobs by giving tax breaks to corporations and derided the Democrats as giving into class warfare. The Democrats, in turn, wanted to boost consumer demand through workers spending their unemployment checks and claimed that the Republican plan was simply a pay-back

for corporate campaign contributors. With this kind of rancor, how does a budget ever get passed?

There are a number of techniques that help achieve compromise. One is a concept known as "incrementalism," where there is a base funding amount that is deemed acceptable by all parties for a particular program. The budget debate focuses on the increment—increase or decrease—for next year's funding. Another technique is "decentralization," where Congress debates lump sums of funding rather than the specific programs funded by those sums. These lump sums can go to a federal bureaucracy or state or local government, where specific spending decisions are made. Finally, there is a great push to compromise because taking extreme positions often brings the government to a standstill, with serious political consequences for whomever the voting public blames for the breakdown. And when compromise is very difficult to forge, for example, during the late 1980s, the federal government has resorted to "budget summits," where the congressional leadership and the president hammer out a compromise behind closed doors. The ultimate product is usually enough of a compromise by all parties that the leadership can take the budget back to Congress for approval.

The History of the Federal Budget

The United States was born in debt. Alexander Hamilton, the nation's first secretary of the treasury, successfully lobbied for the federal government to assume the debt from the states for fighting the Revolutionary War. The states' debt combined with the federal debts owed to both foreign and domestic lenders totaled nearly$100 million. The early federal budget and budgetary process reflected the new nation's fear of strong executive power, entrusting most budgetary power in the legislature. During the eighteenth century and much of the nineteenth century, the departments of government made direct requests for funding to legislative committees.

Until the Republican Party began to create a stronger federal government during and after the Civil War, the federal budget was very small. In fact, even into the twentieth century, the total amount spent by city governments was greater than all the state and federal budgets combined.

The most dramatic tax story before 1940 was the dethroning of the tariff and the creation of an income tax as the primary source of revenue. Most of the federal government's revenue in the eighteenth and nineteenth centuries came from duties on imported goods. Other sources were the sale of public lands and excise taxes on consumer goods, such as tobacco and alcohol. Although the federal government flirted with an income tax to help pay off the North's Civil War costs, there were doubts about its constitutionality. Progressive reformers ended that debate with the Sixteenth Amendment in 1913. Since then, taxes on income—individual and corporate—have been the federal government's largest source of revenue.

The federal budget has tended to accumulate large deficits in times of war and run surpluses in peacetime, which helped to pay the increased interest expenses in subsequent years. After the Civil War, however, civilian spending increased, primarily for pensions to Union veterans and their dependents. The most dramatic increase in civilian spending, however, came in the 1930s during the Great Depression when the federal government started experimenting with ways to reenergize a failing economy and quell the growing unrest of millions of citizens.

Graft, corruption, kickbacks, and rigged contracts are problems as old as government itself. Controlling these problems was a major emphasis of the Progressive Movement reforms of the late nineteenth and early twentieth centuries. Many of the budget reforms that would be incorporated in the federal budget were first tried in the private sector and by local governments. The Budget and Accounting Act of 1921 borrowed many of these ideas, modernized the budget process, and began the current system whereby the president prepares a comprehensive budget for all government spending on an annual basis. It also created the General Accounting Office (GAO) as an independent agency that would facilitate Congress's role in the audit and review of the executive branch.

For over fifty years, the president had more power over the budget than Congress. In the wake of the Watergate scandal, however, Congress reasserted some of its historic budget prerogatives. In 1974, it passed the Budget and Impoundment of Control Act, which among other things gave the Congress more oversight of the president's budget, including the creation of the CBO.

World War II made many permanent changes to the nature of the federal budget. The federal government spent and collected much more money. Federal revenue from individual income tax rose from 17 to 49 percent during the 1940s, and the corporate income tax rose more modestly from 20 to 27 percent of federal revenue. The federal government also began to take a bigger bite out of national income. The ratio of federal tax revenue to GDP doubled in the 1940s. Rising post-war wages also transformed the income tax from something that only rich people paid to a mass tax. The number of people paying income tax rose from 7 million in 1939 to 50 million in 1945. By the end of the twentieth century, nearly 100 million people paid income taxes.

At the middle of the twentieth century, the height of the Cold War, the amount of military spending reached 14 percent of GDP and then steadily dropped into the 4 to 6 percent range until the 1990s, when it hovered around 3 percent. Civilian spending, on the other hand, seems to be a mirror of that trend. It was 6 to 8 percent through the 1950s and into the 1960s, when it began to climb to its high, in 1991, of 15.8 percent. The rise in civilian spending is almost entirely due to increased spending on social security (including hospital insurance). The last important category is net interest on the national debt, which grew rapidly during the budget deficits of the 1980s.

The shortfall between revenue and outlays in any given year is the annual deficit. The accumulated deficits contribute to the national debt. Budget deficits in the 1980s and early 1990s were massive (averaging $223 billion from 1982 to 1993). That trend subsided in the mid-1990s. There were three consecutive surplus years ending in 2000, an achievement not seen since 1949. However, the U.S. government continues to hold a large debt, nearly$5.6 trillion in 2000.

Three congressional acts were created to reign in runaway deficits in the 1980s and early 1990s. They were the Budget and Emergency Control Act of 1985 (also known as the Gramm-Rudman-Hollings Act), the Gramm-Rudman-Hollings Reaffirmation Act of 1987, and the summit-negotiated Budget Enforcement Act of 1990.

An important trend that gained momentum under Richard Nixon is a decentralization of the federal budget, known as "fiscal federalism," which provides state and local governments with block grants from Washington. An extension of this decentralization is evident in the increasing use of tax incentives, rather than budget spending, to achieve public policy goals. For example, in the 2000 campaign for president, both candidates discussed plans to cut taxes to provide incentives for everything from education to energy efficient cars; they did not propose new budget authority for these programs.

BIBLIOGRAPHY

Meyers, Roy T., ed. Handbook of Government Budgeting. San Francisco: Jossey-Bass, 1999.

Musgrave, Richard A., and Musgrave, Peggy B. Public Finance in Theory and Practices. 5th ed. New York: McGraw-Hill Book Co., 1989.

Schick, Allen. The Federal Budget: Politics, Policy, Process. Rev. ed. Washington, D.C.: Brookings Institution Press, 2000.

U.S. Office of Management and Budget. Budget of the U.S. Government. Washington, D.C.: Government Printing Office Budgets from Fiscal Year 1997 forward are available online at www.access.gpo.gov.

Wildavsky, Aaron B., and Naomi Caiden. The New Politics of the Budgetary Process. 4th ed. New York: Addison Wesley/Longman, 2001.

David J.Erickson

See alsoDebt, Public ; Expenditures, Federal ; Revenue, Public ; Revolution, American: Financial Aspects ; Surplus, Federal ; Taxation .

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Federal Budget

FEDERAL BUDGET

An annual effort to balance federal spending in such areas as forestry, education, space technology, and the national defense, with revenue, which the United States collects largely through federal taxes.

Of the three branches of the U.S. government, Congress has the power to determine federal spending, pursuant to Article I, Section 9, of the U.S. Constitution, which states, "No money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law." The drafters of the Constitution sought to secure the federal spending power with legislators rather than the president, to keep separate the powers of purse and sword. In The Federalist No. 58, james madison wrote, "This power of the purse may, in fact, be regarded as the most complete and effectual weapon with which any constitution can arm the immediate representatives of the people."

Still, the Constitution reserved for the president some role in legislative decisions regarding federal spending. The president may recommend budget allowances for what he considers "necessary and expedient," and if Congress does not heed these recommendations, the president may assert his qualified veto power. But the ultimate determinations of federal expenditures belong to Congress.

When the federal government spends more money than it collects in a given year, a deficit occurs. By the mid-1990s, annual budget deficits were exceeding $200 billion, which alarmed the public and caused debate over how to balance the federal budget. President william jefferson clinton was successful in the latter years of his administration to provide a budget surplus, which reduced the national debt (the total amount the government owes after borrowing from the population, from foreign governments, or from international institutions) by several billion dollars. In 2000, Clinton announced a record $230 billion surplus, which exceeded the previous record surplus of $122.7 million set in 1999. However, the deficit returned under President george w. bush. In 2003, Bush announced an estimated $304 billion deficit, which established yet another record. He anticipated a deficit for 2004 of $307 billion.

To encourage better communication and cooperation between the president and Congress on matters concerning the federal budget, Congress has enacted laws formalizing the budget-making process. The first such law was passed in response to an enormous national debt following world war i. The Budget and Accounting Act of 1921 (31 U.S.C.A. § 501 et seq.) required the president to submit to Congress an annual budget outlining recommendations, or budget aggregates. Within budget aggregates recommended by the president, Congress then was to assign priorities. The 1921 act did not change the balance of powers assigned by the Constitution: Congress retained the right to ignore the president's recommendations, and the president retained the right to veto spending legislation. Rather, the act formalized and codified the roles of each branch.

Government Shutdown

Legal commentators have argued that by keeping separate the powers of purse and sword, drafters of the U.S. Constitution encouraged battles between Congress and the president. This friction between government branches is part of the constitutionally created system of checks and balances. Discord over federal budget priorities usually resolves in short order—no politician wants the reputation of jeopardizing the national or world economy. But on rare occasions in the 1990s, budget fights led to federal government shutdowns.

In October 1990, when Democrats in Congress sought to reduce the federal deficit by implementing a surtax on the income of millionaires, Republican President george h. w. bush followed through on a threat to veto any budget legislation that included tax increases. The veto effectively shut down several federal agencies. The closures lasted only three days and occurred on a weekend. Fearing negative fallout from a more extensive government shutdown, Congress and the president reached a compromise plan to reduce the federal deficit without the surtax.

Major differences in political ideologies again surfaced in the fall of 1994, when control of Congress shifted from Democrats to Republicans. The new Congress set a goal of balancing the federal budget by the year 2002, a feat that had not occurred since 1969.

Republicans, buoyed by public sentiment favoring this goal, attempted to implement their balanced budget plan in the fall of 1995. But they faced opposition from many Democrats, among them President bill clinton. Although agreeing with the necessity of a balanced budget, Clinton opposed proposed cuts to entitlement programs such as medicare, medicaid, and welfare. The dispute divided the branches of government as well as political parties, and in November 1995, an impasse led to the expiration of federal funding. Without adequate funding, much of the federal government—including agencies, museums, national parks, and research laboratories— ground to a halt. Some 800,000 government employees deemed "nonessential" were sent home.

Politicians on both sides of the issue faced disapproval from their constituents. Compromises were reached, and a week after it started, the shutdown was over.

Although ideological differences continued, Congress and the White House achieved a budget surplus of $69 billion in 1998. The surplus occurred three years after another partial government shutdown in December 1995 that lasted 21 days. The budget surplus increased to $122.7 billion in 1999 and $230 billion in 2000. Economists projected that the United States could pay off its debts by 2013 if the budget surpluses continued. Those surpluses, however, ended during the administration of President george w. bush. The Bush administration announced a record $304 billion deficit in 2003 and projected that the deficit in 2004 would be about $307 billion.

further readings

Meyers, Roy T., ed. 1999. Handbook of Government Budgeting. San Francisco: Jossey-Bass.

Schick, Allen. 2000. The Federal Budget: Politics, Policy, and Process. Washington, D.C.: Brookings Institute.

As may be expected, the president and members of Congress do not always agree on federal budget issues. In the early 1970s, President richard m. nixon claimed impoundment, which is an executive power to refuse to spend funds appropriated by Congress. Although Nixon argued that he had the right to impound in instances he believed were in the country's best interest, the U.S. Supreme Court affirmed a ruling by the Second Circuit Court of Appeals requiring Nixon to expend federal funds appropriated for the protection of the environment (Train v. New York, 420 U.S. 35, 95 S. Ct. 839, 43 L. Ed. 2d 1[1975]). However, this ruling was based on the terms of a federal water pollution law; the Court declined to address specifically whether the executive branch had the general power to impound funds appropriated by Congress.

Congress responded with the Congressional Budget and Impoundment Control Act of 1974 (2 U.S.C.A. § 190a-1 note et seq.; 31 U.S.C.A. § 702 et seq.). This act sought to restore and strengthen legislative control of the budget by requiring the approval of both the Senate and the House of Representatives for presidential recisions, or current-year cuts in funds appropriated by Congress. The 1974 act also established a budget committee in each congressional house and the congressional budget office to provide technical information and support. Finally, this act required that Congress adopt budget resolutions setting limits on budget aggregates and allowing debates on spending priorities within those aggregates.

The 1974 act greatly reduced the president's role in the budget process—in particular, the president's responsibility of determining and recommending budget aggregates to Congress. Now, legislators could more readily ignore the president's recommendations and instead create for themselves, through budget resolutions, generous limits on budget aggregates. This arrangement allowed politicians more flexibility in setting spending priorities within the budget aggregates, thus pleasing their constituents. Not surprisingly, federal budget deficits grew.

In 1985, Congress reacted to the rising deficits by enacting the Balanced Budget and Emergency Deficit Control Act (popularly known as the Gramm-Rudman-Hollings Act) (Pub. L. No. 99-177, 99 Stat. 1038) (codified as amended in scattered sections of 2, 31, and 42 U.S.C.A.). The Gramm-Rudman-Hollings Act encouraged congressional conformity to deficit reduction targets specifically prescribed by the act. If, after the budget process has been completed, the budget exceeds deficit reduction targets, spending cuts are ordered by the president's office of management and budget. The Gramm-Rudman-Hollings Act limited this executive power by providing congressionally mandated formulas for the spending cuts.

The Budget Enforcement Act of 1990 (2 U.S.C.A. § 601 et seq.; 15 U.S.C.A. § 1022) revised Gramm-Rudman-Hollings to make deficit targets flexible, not fixed. The 1990 act further required that reductions in defense and foreign spending cannot be used to increase domestic spending and vice versa. This requirement is known as the firewall. In addition, the 1990 act required that either revenue increases or spending cuts must balance increases in spending for entitlements, such as Aid to Families with Dependent Children. This requirement is known as pay-as-you-go.

The current federal budget process is extremely complex. Confusion and misunderstandings about the process contribute to disagreements over how to resolve the federal deficit. A very basic description of the process follows.

First, the president sends budget recommendations to Congress. Congress, which has the ultimate power to appropriate federal funds, may follow or ignore the president's recommendations.

Second, the House and Senate together devise an overall budget resolution, usually debating their differences at a conference committee.

Following the guidelines of the budget resolution, House and Senate committees recommend spending for each of thirteen substantive areas. For the House of Representatives, these committees, which loosely correspond with the thirteen substantive areas, include Agriculture; Banking, Finance and Urban Affairs; Education and Labor; Energy and Commerce; Interior and Insular Affairs; Judiciary; Merchant Marine and Fisheries; Post Office and Civil Service; Public Works and Transportation; Science, Space, and Technology; Veterans Affairs; and Ways and Means. For the Senate, the committees, which also loosely correspond with the thirteen substantive areas, are Agriculture, Nutrition, and Forestry; Banking, Housing, and Urban Affairs; Commerce, Science, and Transportation; Energy and Natural Resources; Environment and Public Works; Finance; Governmental Affairs; Judiciary; Labor and Human Resources; and Veterans' Affairs. The full House and Senate together vote on the recommendations of the committees, following debate in a conference committee if necessary. The House and Senate then jointly send an authorization bill for each of the thirteen substantive areas to the president for signing. These bills merely establish guidelines for spending; they do not actually authorize spending.

Next, the House and Senate Appropriations Committees together draft thirteen separate appropriations bills, which correspond to the authorization bills. The full House and Senate together approve or disapprove each appropriation, conduct debates in conference committees to resolve differences, and amend appropriations if necessary. They then jointly send the thirteen appropriations bills to the president to be signed. If the bills are signed, spending is approved.

Upon congressional funds appropriations, the branches and agencies of the federal government are required to spend the funds on the functions for which they were appropriated. Congress may supplement budget appropriations if conditions change following the budget process, but supplemental appropriation in excess of authorization bills must be accounted for with spending cuts, amendment of the individual authorization bills, or amendment of the overall budget bill containing all the individual authorization bills.

Several wrinkles complicate the federal budget process. For example, Congress and the president enact as law permanent authorization and spending appropriations for entitlement programs such as medicare and medicaid. Thus, appropriations for entitlement programs become automatic, requiring no further congressional action during the annual budget process.

Appropriations funding the principal and interest owed on the national debt are, practically speaking, also automatic. Unlike appropriations for entitlement programs, those for the national debt must be approved annually by Congress. But approval for funding this debt is always granted; to allow the United States to default would severely damage the national and world economies. In the debate over how to balance the federal budget, politicians and citizens often overlook automatic federal spending.

Also complicating the budget process is the method of accounting used by the federal government, known as the cash method. The cash method of accounting calculates expenditures based upon the date they are paid. This method differs from the accrual method of accounting, which calculates expenditures based on the date the obligation is incurred. Although this may seem to be a subtle distinction, the cash method by its nature leaves more room for error in budget appropriations, some of which is corrected by a government statistic called the National Income and Product Accounts. Economists, politicians, and concerned U.S. citizens disagree over which accounting method, cash or accrual, would better serve the U.S. budget and the national economy. Moreover, economics is an inexact science whose complexities are not well understood by the average voter.

Added to the public's general confusion is the difficulty in estimating the federal budget, both revenues and expenditures, before the start of a fiscal year. Future unemployment, inflation, and growth in the gross national product are variables that will affect actual federal spending. And although the treasury department and the Senate Finance Committee estimate future revenues, no accurate determination will be available until the fiscal year has already ended.

Largely because the budget process is so complex, there is little agreement as to how to balance the federal budget. As the federal deficit lingers each year, so does public support of a constitutional amendment requiring a balanced budget. Yet several attempts at such legislation— in 1984, 1990, 1992, and 1994—have failed to pass in Congress. One vocal proponent of a balanced budget amendment is Texas businessman H. Ross Perot, who ran unsuccessfully for president in 1992. Perot denounced mushrooming deficits, blaming politicians who approve current spending to appease constituents at the expense of future taxpayers: "[I]n 1992 alone we will add over $330 billion to the $4 trillion we've already piled on our children's shoulders…. The weight of that debt may destroy our children's futures."

Yet a balanced budget amendment would not be without obstacles. One problem is defining a balanced budget, especially given the confusion over federal accounting methods, automatic expenditures, and inaccurate estimates of revenue and spending. For example, a federal budget employing the cash method of accounting may show a far greater deficit than the same budget employing the accrual method of accounting.

Another problem is that of the enforceability of a balanced budget amendment, which hinges in part on taxpayer standing, or legal entitlement to sue. Would all taxpayers have standing to enforce a balanced budget amendment, or would only taxpayers who could demonstrate actual damage as a result of an unbalanced budget? Further, courts are reluctant to make determinations of what they consider political questions, or issues best decided by the legislative or executive branch of government. Many commentators consider the judicial branch incapable of effectively analyzing and deciding issues concerning the federal budget.

Perhaps the greatest impediments to a balanced budget amendment, or any other meaningful reform of the federal budget, are the sacrifices faced by U.S. citizens: to have their taxes raised and their spending programs cut. Whether Congress, the president, and the public will make these sacrifices to reduce and perhaps eliminate the federal deficit is an engaging political question.

further readings

Bowen, James W. 1994. "Enforcing the Balanced Budget Amendment." Seton Hall Constitutional Law Journal 4:565.

Devins, Neal. 1990. "Budget Reform and the Balance of Powers." William and Mary Law Review 31.

Schick, Allen. 2000. The Federal Budget: Politics, Policy, and Process. Rev. ed. Washington, D.C.: Brookings Institution.

Shojai, Siamack, ed. 1999. Budget Deficits and Debt: A Global Perspective. Westport, Conn.: Praeger.

cross-references

Accrual Basis; Cash Basis; Congress of the United States; Constitution of the United States; Independent Parties; Reform Party; Separation of Powers.

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