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Where does federal spending go?

October 3, 2016 GMT

One of the most common questions I get regarding the national debt is what will happen when interest rates increase and the debt grows such that interest payments become a bigger and bigger portion of the federal budget.

To answer that question, it is helpful to take a detailed look at current federal government expenditures and projections for the decades ahead.

In fiscal year 2015, which ended last September, the U.S. federal government spent $3.7 trillion, which equates to just over 20 percent of the nation’s gross domestic product (GDP), a measure of the dollar value of a country’s output of goods and services.

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The sources for that figure and the other data in this article include the Federal Reserve Bank of St. Louis; the Office of Management and Budget; the Congressional Budget Office; the U.S. Treasury; and the Center on Budget and Policy Priorities, a nonpartisan research and policy institute.

The federal government funded $3.2 trillion, or approximately 86 percent of its 2015 spending, with taxes and other revenues. $438 billion, or roughly 14 percent of the spending, was funded by issuing government debt.

In 2015, 47 percent of federal revenue was from individual income taxes while 11 percent came from income taxes paid by corporations. About 33 percent of federal revenue was from social insurance and retirement receipts, including Social Security and Medicare taxes. The remaining 9 percent of federal revenue is from excise taxes and other sources.

The $438 billion borrowed to fund the government is known as the federal budget deficit and equates to approximately 2.5 percent of GDP for fiscal year 2015. For comparison, the budget deficit in fiscal year 2009 in the aftermath of the Great Recession was $1.4 trillion, or 9.8 percent of GDP.

Since the federal budget deficit represents spending that is funded with borrowing, the budget deficit amount gets added annually to the national debt, which as of September 2016 stood at $19.5 trillion.

Total government debt as a percent of GDP is 105 percent, compared to 63 percent immediately before the Great Recession. Much of the debt is owned by federal agencies in the form of government bonds and notes. For example, the Social Security Trust Fund owns $2.8 trillion in U.S. Treasury securities.

When we exclude debt the government owes to itself, there remains $14.1 trillion of public debt held by investors, foreign entities, and the Federal Reserve. This equates to 76 percent of GDP.

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Foreign entities are the largest holder of public debt at $6.2 trillion, followed by the Federal Reserve at $2.5 trillion.

Now that we know how the federal government receives funding, where does the government spend the money?

In 2015, the largest federal spending amount was for health care and insurance expenses tied to Medicare, Medicaid, Children’s Health Insurance Program and marketplace subsidies for the Affordable Care Act. This equaled $938 billion, or 25 percent of federal expenditures.

Medicare, which provides health coverage to 55 million people over 65 as well as the disabled, accounted for two-thirds of the healthcare spending, or $546 billion. Subsidies for the health care exchanges cost the federal government $28 billion in 2015 and were paid to 8 million of the 11 million applicants who purchased insurance on the health care exchanges.

The second highest federal budget item is Social Security, which provides monthly retirement benefits averaging $1,342 to 40 million retired workers as of December 2015. Social Security also makes payments to 2.3 million spouses and children of retired workers, 6.1 million surviving spouses and children of deceased workers and 10.8 million disabled workers.

Social Security spending was $888 billion, or 24 percent of the federal budget.

Sixteen percent of the federal budget, or $602 billion, is spending on national defense and international security assistance.

Ten percent of the budget is for social safety net spending, including unemployment benefits and the earned income tax credit for low-income working families.

Eight percent of the federal budget goes toward benefits for federal retirees and veterans while 11 percent was spent on other federal programs, including transportation infrastructure, education, science and medical research.

The remaining 6 percent of federal spending goes toward interest on the national debt held by the public. With $14.1 trillion of debt held by the public in the form of government bonds and notes, interest paid in 2015 was $223 billion, which imputes to an average interest rate of approximately 1.7 percent.

Interest as a percent of GDP was 1.2 percent in 2015, approximately where it was from the 1950s to the mid-1970s. During the 1980s as interest rates soared, interest as a percent of GDP climbed. It peaked at 3.1 percent of GDP in 1991 and has been declining since then.

Collectively, 67 percent of annual federal spending flows to households to cover living expenses, including healthcare-related costs. In other words, a dollar spent by the federal government ends up as someone else’s income, either a household, business or government entity.

The government is a pay-as-you-go system, which means while the beneficiaries of many of these federal benefits feel like they paid into the system over the years and have “earned” the benefits, the money was never saved. It simply flowed into the federal coffers to be paid out the same year the money was received.

The national debt is a liability of the federal government. It is also an asset for the households, businesses and governments who own that debt in the form of government bonds and notes.

Every dollar of interest the federal government spends on interest payments is also someone else’s income.

The federal government is essentially a pass-through vehicle that collects revenue and borrows funds from households, business and governments and then turns around and spends the money collected on households, businesses and governments.

This might seem obvious, but to answer the original question, what happens when interest payments on the national debt become a larger proportion of the federal budget?

As the debt grows and interest rates increase, all it means is a greater proportion of household and business income will come from interest income and less from retirement and healthcare benefits.

We pay the money in, and it flows right back to us.

David Stein hosts the weekly Money For the Rest of Us show at moneyfortherestofus.net During the summers he lives on a farm in the Teton Valley, which is about 50 miles northeast of Idaho Falls. He also runs the Money For the Rest of Us Hub, an investment education platform. Previously, he was chief investment strategist for an institutional investment advisor. David can be reached at jd@jdavidstein.com.