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5.4: Role of Government in the Free Enterprise System

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    Figure 5.4.1: Yellowstone National Park was affected by the Government Shutdown.

    So you trekked all the way to Wyoming to see Yellowstone National Park in the beautiful month of December 2018, only to find it closed. Closed! Why?

    In December 2018, the U.S. federal government shut down because an agreement could not be reached regarding federal funding and immigration issues. Many federal services, like the national parks, closed and 800,000 federal employees were furloughed. Tourists were shocked and so was the rest of the world: Congress and the President could not agree on a budget.

    The shutdown was caused by disputes over the status of protection of persons affected by the Deferred Action for Childhood Arrivals (DACA) immigration policy, and therefore whether those covered under the program should face deportation. There was also a dispute over whether funding should be funded towards building a Mexico–United States border wall, a keystone policy during Donald Trump's presidential campaign.

    Shutdowns cause the disruption of government services and programs, including the closure of national parks and institutions (in particular, due to shortages of federal employees). A major loss of government revenue comes from lost labor from furloughed employees who are still paid, as well as the loss of fees that would have been paid during the shutdown. Shutdowns also cause a significant reduction in economic growth (depending on the length of the shutdown).

    Video: What the Government Shutdown Means for Travel, Mail, and Social Security


    Why does the federal budget create such intense debates? What would happen if the United States actually defaulted on its debt? In this section, we will examine the federal budget, taxation, and fiscal policy. We will also look at the annual federal budget deficits and the national debt.

    All levels of government—federal, state, and local—have budgets that show how much revenue the government expects to receive in taxes and other income and how the government plans to spend it. Budgets, however, can shift dramatically within a few years, as policy decisions and unexpected events shake up earlier tax and spending plans.

    Fiscal Policy

    In this section, we review fiscal policy. Fiscal policy is one of two policy tools for fine-tuning the economy (the other is monetary policy). While monetary policy is made by policymakers at the Federal Reserve, fiscal policy is made by Congress and the President.

    The discussion of fiscal policy focuses on how the federal government taxing and spending affects aggregate demand. All government spending and taxes affect the economy, but fiscal policy focuses strictly on the policies of the federal government. We begin with an overview of U.S. government spending and taxes. We then discuss fiscal policy from a short-run perspective; that is, how the government uses tax and spending policies to address recession, unemployment, and inflation; how periods of recession and growth affect government budgets; and the merits of balanced budget proposals.

    Government Spending

    Government spending covers a range of services provided by the federal, state, and local governments. When the federal government spends more money than it receives in taxes in a given year, it runs a budget deficit.

    In contrast, when the government receives more money in taxes than it spends in a year, it runs a budget surplus. If government spending and taxes are equal, it is said to have a balanced budget. For example, in 2009, the U.S. government experienced its largest budget deficit ever, as the federal government spent $1.4 trillion more than it collected in taxes. This deficit was about 10 percent of the size of the U.S. Gross Domestic Product (GDP) in 2009, making it by far the largest budget deficit relative to GDP since the mammoth borrowing used to finance World War II.

    Total U.S. Government Spending

    The major federal spending categories: national defense, Social Security, health programs, and interest payments. From the graph, we see that national defense spending as a share of GDP has generally declined since the 1960s, although there were some upward bumps in the 1980s buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11, 2001. In contrast, Social Security and healthcare have grown steadily as a percent of GDP. Healthcare expenditures include both payments for senior citizens (Medicare), and payments for low-income Americans (Medicaid). Medicaid is also partially funded by state governments. Interest payments are the final main category of government spending shown in the figure.

    Federal Spending, 1960–2010

    Figure 5.4.2

    Since 1960, total federal spending has ranged from about 18 percent to 22 percent of GDP, although it climbed above that level in 2009. The share spent on national defense has generally declined, while the share spent on Social Security and on healthcare expenses (mainly Medicare and Medicaid) has increased. (Source: Economic Report of the President, Tables B-80 and B-1,

    Each year, the government borrows funds from U.S. citizens and foreigners to cover its budget deficits. It does this by selling securities (Treasury bonds, notes, and bills)—in essence borrowing from the public and promising to repay with interest in the future. From 1961 to 1997, the U.S. government has run budget deficits, and thus borrowed funds, in almost every year. It had budget surpluses from 1998 to 2001, and then returned to deficits.

    The interest payments on past federal government borrowing were typically 1–2 percent of GDP in the 1960s and 1970s but then climbed above 3 percent of GDP in the 1980s and stayed there until the late 1990s. The government was able to repay some of its past borrowing by running surpluses from 1998 to 2001 and, with help from low interest rates, the interest payments on past federal government borrowing had fallen back to 1.4 percent of GDP by 2012.

    These four categories—national defense, Social Security, healthcare, and interest payments—account for roughly 71 percent of all federal spending, as Figure 2 shows. The remaining 29 percent wedge of the pie chart covers all other categories of federal government spending: international affairs; science and technology; natural resources and the environment; transportation; housing; education; income support for the poor; community and regional development; law enforcement and the judicial system; and the administrative costs of running the government.

    Slices of Federal Spending, 2012

    Figure 5.4.3

    About 71 percent of government spending goes to four major areas: national defense, Social Security, healthcare, and interest payments on past borrowing. This leaves about 29 percent of federal spending for all other functions of the U.S. government. (Source: Economic Report of the President, Table B-80,

    In 2015 the total government expenditures, by all levels of government was $6.2 trillion. On a per capita, or per person basis that would have been $19,386/person. The pie chart shows the total spending, or the percentage of spending by categories, for the U.S. in the fiscal year 2015.

    Figure 5.4.4

    Government spending is often described as spending in the "public sector" or the part of the economy that is made up of the federal, state, and local governments. Economists agree that government spending began to grow significantly during the Great Depression (1929-1939), and then grew exponentially during World War II.

    The economic crisis of the Great Depression and the programs instituted by Franklin D. Roosevelt changed public opinion about what the government's role should be in everyday economic affairs. The success of the New Deal programs to provide relief, recovery, and reform for Americans, set the stage for the unprecedented growth in government spending.

    Over the years, many Americans have accepted the expansion of government spending as part of the increase in government regulation of the free market economy and the development of social programs since 1932.

    What the government does not provide, the private sector, or the part of the economy made up of private individuals and privately owned businesses, provides. So the economy is either categorized as either the public sector (government) or the private sector (not government).

    Types of Spending

    Spending is also termed expenditures, and the government spends money in the form of purchasing goods and services or as transfer payments. The government is a significant "consumer" in the private sector. It purchases vast amounts of goods to be used by its employees in its office such as computers, paper, copy machines or tables. It buys equipment for schools and universities, for the military and even for various departments that the government has created such as the Department of the Interior, or the Department of Transportation. The government also provides services to the public by spending money to hire workers that staff the various departments, agencies, and the military.

    Transfer payments are another form of expenditure. Transfer payments are paid out to certain individuals, such as those who receive Social Security, disability for military service, welfare, or unemployment compensation. The government does not receive a good or service for these payments, however, the money that the government provides to these recipients makes it possible for them to participate in the economy.

    Another type of transfer payment is known as a "grant in aid" where one level of government transfers money to another level of government. The federal government grants money to the states and local governments for specific purposes such as road construction, education, and urban renewal. The money generally has "strings attached" which means that it can only be spent for the reason that it was given and that recipient must follow the rules for how it is to be spent. If the money is not spent correctly, the money must be repaid to the federal government.

    The size of the expenditures from "public sector" has an enormous impact on the allocation of resources. When the government spends money it impacts both state and local economies. If the government decides to fund a particular state program or local agency it can bring jobs and growth to that area, however, the opposite is also true. If the government cuts a program or ends funding for a project it may increase unemployment or impact a local economy.

    Another way that funding impacts the economy is the distribution of income. When the government increases or decreases transfer payments it directly impacts those who receive those payments. If the government decides to spend money on defense and the military, then it can shift which part of the economy will benefit. In addition, the government can help a particular group that may be in need, such as farmers.

    Finally, some economists believe that the government can compete with the private sector when it provides goods and services. For example, public schools and universities compete with private educational facilities; or veteran's hospitals have the same health services that public hospitals provide.

    Figure 5.4.5

    Study/Discussion Questions

    1. Explain why and how government expenditures have grown since the 1940s.

    2. Describe the two kinds of government expenditures.

    3. Explain how government spending impacts the economy.

    4. Why has the federal government’s role in the national economy grown over the last 100 years?

    5. Has the national government helped or hindered the nation’s economic growth since the 1940s?

    6. How have current economic goals of the government impacted government spending?

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