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The Effects of Federal Spending and Federal Debt

The federal government spends an enormous amount of money each and every year. In 1998 the government spent over 2 trillion dollars. Clearly spending of this nature will have a significant impact on the American economy.

The government spending impacts the economic in the following ways:

  • It affects the allocation of resources - where government programs are created or bases built redistributes capital. If we close a base in Podunk and open one in Tuskegee the citizens in Podunk lose a substantial form of income. Likewise choosing one government contractor over another or building roads in one area over another has dramatic impact. In the case of agriculture this may mean price support legislation that impacts on different areas of the country.
  • Affects the distribution of income - Income for the poor is directly effected by changes in transfer payments. Taxes have what I call the Robin hood effect. They take from the rich and give to the poor. This is redistribution of wealth and income. Government expenditures effect the income of individuals depending on the contracts the government enters into. Base closings, factory closings etc.
  • The government may compete with the private sector - Government run hospitals, other health departments that compete with private facilities are an example of such competition. While this competition may not always be a positive externality it may be. On the negative side said government run facilities may force private employers out of business because private firms need to operate in terms of profit and loss and the government run facilities have no such consideration. On the positive side, however, having government run facilities compete against the private sector may create the kind of competition needed to improve services.

When the government spends more in a given year then it takes in that means there is a deficit. When this deficit is carried over from year to year it is a debt. In 1900 this nation was basically debt free, approximatley 2 billion dollars which is an inconsequential figure, even in those days. In 1929 the debt was 16.9 billion and when the Depression began and World War II occurred the United States under Franklin Delano Roosevelt began true deficit spending. All of those New Deal programs were paid for with money we did not really have. The debt in 1940 ran to 42.9 billion and mushroomed to 258 billion as the nation foughjt World War II. From 1945 through 1961 the debt grew minimally, increasing to only 296 billion in 1961. When one factors in inflation this means the value of the debt declined significantly. Even through the 1960s and 70s which included Vietnam, the space race and the arms race the debt only grew modestly increasing to 789 billion in 1979. This was still a relatively low and manageable amount factoring inflation and growing GNP. Our real debt problems began during the Ronald Reagan administration. In 1981 Reagan passed the Emergency Recovery Tax Act that lowered taxes but increased spending, especially on the military. This basically created an enormous debt. nder the Reagan administration the debt grew from 930 billion in 1980 to 2.6 trillion dollars in 1988. This means the debt grew 300% in eight years after only growing about 150% from 1950 to 1979. In 1997 our national debt reached 5.4 trillion and only during the economic boom during the Clinton administration did it slow. In 1998 the debt was 5.5 trillion, in 1999 it was 5.6 trillion and was the same in 2000. Since the election of George Bush the debt has begun to rise again. In the four years the Bush has been in office, and again cutting taxes while increasing spending, the debt has risen from 5.8 trillion in 2001 to its current high of over 7 trillion dollars. (all figures available at

The federal deficit affects the federal budget in a variety of ways. Deficit spending is spending more than is collected in revenues. Sometimes a deficit is planned by the government, or sometimes it occurs because factors in the economy have reduced the amount of revenues or increased the amount of expenditures. In 1994, the government predicted a $264 billion federal spending deficit. From where it stood in 1993, the government said that the economy could go one of two ways. It could either be stronger than expected meaning that the federal revenues would go up and expenditures, thus cutting the deficit. Or the economy could be weakened and tax collections would decrease. People would lose their jobs, and unemployment compensation would rise, thus increasing the deficit. In recent economic history, it seems as though deficits tend to appear more frequently than surpluses. The largest deficits occurred during WWII, and throughout the 1980's with the implementation of Reaganomics. When the government runs a deficit, it must borrow money from others in order to finance the shortage of income. Generally this is done by having the Department of the Treasury sell bonds and other forms of government debt to the public. If all federal bonds and other debt obligations are added up, then there is a measure of the federal debt. This debt increases whenever the government sells more bonds to finance deficit spending in a given year. It will continue to grow as long as the government spends more than it collects in revenues. Therefore, if the government turns up a zero budget deficit one year, that doesn't mean that the debt will go away, instead it means that it won't get any larger.

There are many ways in which the national debt can affect the overall state of the economy.

1) Public v. Private debt- Public debt is where we owe most of the federal debt to ourselves whereas private debt is owed to others. One of the fundamental differences between the two is that when a person goes into debt by borrowing money from a bank there is then established a repayment system or agreement. When the federal government borrows money, however, it gives little thought to how it will be repaid, let alone when. Yet in all actuality, there is no real reason as to why the government would have to pay off the federal debt. When it is time to pay off old bonds, the government issues new ones. Another difference between the two types of debt has to do with the loss of purchasing power. To an individual who borrows money, they sacrifice a good portion of their purchasing power because the money is gone and cannot be used to buy more goods and services. When the federal government repays a debt, there is no loss of purchasing power because the taxes and revenue collected from some groups are then transferred to others.

2) The Distribution of Income - Theoretically speaking, if the government borrows money from the wealthy, and as a result the burden of taxes falls on the middle class and the poor, taxes would be transferred to the rich in the form of interest payments on the debt. If the government borrows money from the middle class instead, and if the burden of taxes fall on the rich, those taxes would be used to make interest payments to the middle class. The federal tax structure determines the distribution effects.

3) A Transfer of Purchasing Power- Federal debt causes a transfer of purchasing power from the private sector to the public sector. As a rule, the larger the public debt, the larger the interest payments, hence the more taxes needed to pay them. As a result, the public has less money to spend on their own needs.

4) Individual Incentives - taxes needed to pay the interest can cut down the incentives to work, save, and invest. Individuals and businesses might feel less inclined to work harder and earn extra income if higher taxes will be placed on them. Many people feel that the government spends taxpayers' money in a heedless manner. If people feel that their taxes are being squandered, they are less likely to save and invest.

5) Higher Interest Rates - When the government sells bonds to finance the deficit, it competes with the private sector for scarce resources. At times there is the crowding-out effect Private borrowers are forced to pay the higher rates or leave the market. The increased demand for money causes the interest rate to go up. This increases forces borrowers to either pay higher rates, or to stay out of the market.

In recent years there have been many attempts by the government to bring the federal deficit under control. One of the first actions taken by Congress was the Balanced Budget and Emergency Deficit Control Act of 1985, or Gramm-Rudman-Hollings (GRH) that tried to mandate a balanced budget. The central idea in the GRH was a set of federal deficit targets for Congress and the President to meet over a six year span of time. The federal deficit was to decrease each year until it reached zero in 1991. If in event, Congress and the President could not concur on a budget that met the target in any given year, the automatic reductions would take over and reduce spending. Splitting reductions equally between defense and non defense expenditures would do this. This law was popular among legislatures because it reduced spending without forcing Congress to vote against popular programs. Yet in the long run, the GRH failed, leaving the country with a deficit of $269.5 billion in 1991. The reasons behind it were simple. First, Congress discovered that there was a loophole in the law that allowed it to pass spending bills that took effect two or three years later. Because the GRH only set the deficit estimate for one year at a time, these bills didn't conflict with GRH. Secondly, in July of 1990, the economy began to decline. This triggered a safety valve in the law that suspended automatic cuts when the economy was weak. The combination of spending bills that encompassed GRH, the suspension of automatic budget cuts, and the lower federal revenues caused by the declining economy all added to the enormous budget deficit. As a result, a balanced budget never occurred. Another piece of legislation passed by Congress was the Budget Enforcement Act (BEA) of 1990. The main attributes to this law were the act of combined spending caps with a "pay-as-you-go" provision in attempts to limit discretionary spending. Under this provision, reduction somewhere in the budget had to counteract any new program that required additional spending. The BEA also required that five-year revenue estimates be prepared for each new legislative act. If offsetting cost reductions could not be found, then across-the-board spending cuts would be made to offset the extra costs. Though the BEA was harder to get around than the GRH, it was limited by several provisions. First, it applied only to discretionary spending, therefore excluding Social Security and Medicare. Second, it included a safety provision that allowed for suspension of the act if the economy enters a low-growth phase, or if the President declares an emergency. A third piece of legislation was the Omnibus Budget Reconciliation Act of 1993. Designed by President Clinton, this Act was an attempt to trim approximately $500 billion from the deficit over a five-year period. With the enormously high deficit in 1993, the act was intended to reduce only the rate of growth of the deficit. The major provisions of this package were tax increases and spending reductions. The program made the personal income tax even more progressive, and targeted the richest percentage of Americans for a tax increase.

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