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 The
federal budget is, at its simplest, a plan for federal spending and revenues for
a given year. The budget also contains reviews of past spending, some forecasts
for future spending and revenues, and an assessment of the government's fiscal
situation.
We begin our look at the federal budget with the big picture: what
does the federal government spend its money on? The figure below shows the President's
proposed budget for fiscal year 2009, which begins October 1 (2008). It shows
that President Bush proposes a budget of $3.1 trillion for 2009, divided into
the major categories of federal spending shown on the chart. 
(click on any chart to see a full-size version in PDF)
The first few slices
(in blue) are discretionary spending, making up one-third of the budget, and subdivided
into defense and nondefense. Discretionary spending is called discretionary
because, as the name implies, it's optional. Congress and the President must decide
each and every year what to spend on discretionary spending, or the money doesn't
get spent. (The two pie slices coming out of the chart show defense R&D and
nondefense R&D, to illustrate that nearly all of the federal R&D investment
is discretionary, and split between defense and nondefense.) Defense
discretionary is a little more than half of all discretionary, and roughly
one-sixth of the total budget. The entire military budget for the Department of
Defense (DOD) is here, as well as defense spending in other agencies such as the
nuclear weapons work of the Department of Energy (DOE). Nondefense discretionary
is a little less than half of all discretionary, and again roughly one-sixth
of the total budget. Though small, this part funds nearly all the visible functions
of the federal government outside defense: national parks, air traffic control,
border enforcement, environmental protection, Smithsonian museums, veterans hospitals,
etc. Except for military personnel, all federal employees including the President
and members of Congress, federal judges, airport security workers, and Coast Guard
officers receive their salaries from this part of the budget. Nondefense discretionary
also contains funding that flows to state and local government such as highway
funds and education grants. It also contains funding for our international programs,
covering foreign aid, contributions to international organizations, and our diplomatic
network of embassies and consulates abroad. The budgets for all of these programs
(even the military) have to be decided every year in the federal budget process,
meaning there's no guarantee that any of them will continue from year to year.
This fact alone helps explain why people representing every imaginable constituency
come to Washington, DC, every year to lobby for funding. What about the
remaining two-thirds of the federal budget? The slices in red, orange, and gray
represent mandatory or entitlement spending because this spending is automatic
and guaranteed under federal law, without the need for annual appropriations.
The largest three entitlements are Social Security, Medicare, and Medicaid.
Spending for Social Security, for example, is set in permanent law: for workers
who have paid Social Security taxes, there is a formula for determining eligibility
for benefits, the amount of benefits, and even cost-of-living adjustments. Eligible
recipients will receive a Social Security check automatically, even if Congress
and the President do nothing this year. Likewise, people over 65 are automatically
entitled to a Medicare benefit according to amounts established in permanent law.
Medicaid is a state-federal partnership in which the federal government sets eligibility
minimums. Other mandatory programs include federal retirement programs, food stamps,
guaranteed student loans, and agricultural price supports: all of these programs
automatically spend money based on eligibility formulas, and most of these programs
have their spending levels determined for 5 years at a time. The last category
is net interest on the national debt: this is also mandatory, because holders
of federal government debt have to be paid. For these programs, the federal budget
is mostly an annual estimate of how much these programs cost, calculated by combining
estimates of eligible populations, benefit levels, and inflation or interest rate
adjustments. Congress and the President don't have to take action on permanent
entitlements, unlike discretionary programs, but of course they always have the
option of proposing changes in the law in the federal budget to add benefits or
to control costs. A few years ago, for example, they changed Medicare to add a
prescription-drug benefit, which took effect in 2006. Lawmakers have to take action
on other entitlements, but not every year: in June 2008, Congress finalized a
5-year farm bill to renew mandatory farm and nutrition programs through 2012.
The current situation of one-third discretionary and two-thirds entitlements
is very different from the past. In the '60s, for example, the ratio was reversed
and in the '70s and early '80s it was half-half. But automatic growth in the three
large entitlement programs means that policymakers have little room to maneuver
these days unless they tackle Social Security, Medicare, and Medicaid, all of
which tend to grow rapidly because of automatic inflation adjustments, increases
in eligible populations, and the ballooning cost of medical care. The figure
below shows how the $3.1 trillion in spending is paid for. Each year, the federal
budget has to estimate federal revenues, which can vary greatly depending on economic
conditions. The federal budget can propose changes in the revenue structure through
tax increases or tax cuts. More than 80 percent of federal revenues come from
individuals through their income and payroll taxes. The majority of Americans
pay more in payroll taxes for Medicare and Social Security than income tax. Corporate
taxes used to be a larger share of revenues, but recent tax cuts have reduced
this share. Other taxes are relatively small. Total revenues are projected at
$2.7 trillion, falling short of spending, and because the budget does not propose
tax increases to make up the difference the remainder has to be borrowed. 
The figure below shows that revenues and spending have fluctuated over
time. Federal spending has been roughly 20 percent of the U.S. Gross Domestic
Product over time, or one-fifth of the U.S. economy. As a share of the economy,
federal spending actually declined from the early 1980s and dipped below 20 percent
in the late 1990s before climbing above 20 percent this decade because of growing
entitlements and increased spending on homeland security and wars. Federal revenues,
meanwhile, fell dramatically from 21 percent to 16 percent of GDP this decade
because of the series of tax cuts enacted between 2001 and 2005, but are now creeping
back up. 
The
gap between spending and revenues each year makes up the budget deficit or
surplus. The red or black bars in the figure below show the budget deficit
or surplus in inflation-adjusted dollars for the last 45 years, and projections
for the next 5. During most of the 1990s, policymakers in both parties tried repeatedly
to control the federal deficit by raising taxes and restraining spending. In 1998,
the federal budget reached surplus for the first time since 1969, and policymakers
in both parties promised to keep the budget in surplus. But after four years of
surpluses, the budget fell back into deficit in 2002 because of tax cuts totaling
$2 trillion over a decade, a recession, and increased spending on domestic programs,
homeland security and the military for wars in Iraq and Afghanistan. In 2004,
the deficit hit an all-time high. The 2005 budget deficit was $319 billion, down
from the year before but still the third-largest deficit in history. The budget
contains projections for the next few years. They show the deficit declining until
a surplus appears in 2012, but they are based on some questionable assumptions:
that tax cuts scheduled to expire will not be extended; that further emergency
spending for wars, disaster relief, and homeland security will not be needed;
that discretionary spending will be restrained in future years; and that no more
money for Iraq and Afghanistan will be needed in the future. The deficit projection
below was made in February 2008 and is already out of date; because economic growth
has slowed more than anticipated since then, in July 2008 the Office of Management
and Budget revised its deficit forecast to $482 billion in FY 2009, which would
be the largest deficit in history. 
The
line on the chart shows what is called the 'on-budget' surplus or deficit.
Legally, Social Security is classified as 'off-budget,' although it is definitely
part of the federal budget, so the rest of the budget is 'on-budget'. This distinction
is made because policymakers wanted to keep Social Security's finances somewhat
separate from other federal spending: current payroll taxes (FICA taxes) pay for
current Social Security benefits, and since the 1980s the program has been designed
to run large annual surpluses in order to prepare for the retirement of the Baby
Boom generation beginning in a few years. Currently, Social Security takes in
close to $200 billion more each year than it pays out in benefits; this surplus
is invested by law in Treasury securities. As the Baby Boom generation starts
collecting benefits, this annual surplus will dwindle and turn into a deficit
around 2018. At that time, Social Security will begin redeeming its stack of Treasury
securities to pay a portion of benefits. This arrangement means that right
now, the Social Security surplus of roughly $200 billion a year helps to
pay for the rest of the federal government. The line shows that without the Social
Security surplus, the federal government would be running annual deficits over
$600 billion. Beginning in 2018 or so, the flow would reverse: the rest of the
federal government will begin to help pay for Social Security. At the turn of
the century, there was talk of maintaining a budget surplus without Social Security,
which happened in just two years (1999 and 2000), to help shore up the government's
long-term finances. Clearly, this has not happened. Some lawmakers have proposed
to use the Social Security surplus to pay for private retirement accounts. The
sum of the government's annual deficits and surpluses is the national debt,
representing the total amount the federal government has borrowed. There are two
parts of the national debt, as shown in the figure below. In orange is the 'debt
held by the public,' meaning what the federal government owes everyone else.
Whether in the form of Treasury securities or savings bonds, federal debt is held
by central banks of other nations, banks, other financial institutions, and any
individual owning a U.S. savings bond. Currently, this national debt is over $5
trillion. The figure shows that between 1998 and 2001, this debt declined as four
years of budget surpluses allowed the government to pay down some of this debt.
This decade, the debt has climbed and will continue to do so as long as the federal
budget runs deficits each year. 
The
other part of the debt is government-held debt, meaning debt that one part
of the federal government owes another part. Mostly, this means debt that the
Social Security trust fund has accumulated through its decades of Social Security
surpluses invested in Treasury securities. In 12 years or so, Social Security
will begin redeeming this debt to pay for benefits. The figure shows that government-held
debt is projected to grow dramatically over the next few years. These two debts
together are the 'debt subject to limit,' also called the debt limit. Periodically,
Congress and the President have to raise the national debt limit, which is the
legal amount the U.S. Treasury can borrow. In July 2008, Congress and the President
agreed to the raise the debt limit to $10.6 trillion as part of the housing relief
bill. The big budgetary challenges are still around the corner, from 2010
onward. As the Baby Boom generation hits retirement age, spending on the big three
entitlement programs of Social Security, Medicare, and Medicaid will balloon unless
drastic changes are made. Yet instead of restraining these costs, policymakers
are more inclined to add to them: a new Medicare prescription-drug benefit phased
in beginning in 2006.
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