Most of us are taught at a young age that we
should avoid spending money that we don’t have. We are taught to earn and save our money, and
to only borrow money as a last resort. Indeed, even as adults most of us believe that debt,
or something owed by one party to another, is a negative thing. However, the truth is
more complicated, especially with regards to governments. In this tutorial, we will be
looking at how governments spend their money, and where they get money from if they don’t have it.
Government spending meets a wide variety of needs. It covers the costs of resolving conflicts,
defending a society from other societies, and provides public services that
benefit the entire population. Ideally, all government spending is funded by taxes,
or required payments to the government. We will learn about the different types of taxes
in the next tutorial, but it is the case that literally anything can be taxed, and some things
can seem arbitrarily taxed. However, most citizens accept that taxes are a necessary way to fund the
government, whether they like paying them or not. But what if the government doesn’t receive taxes
to pay for all its obligations? Well just as individuals must borrow money to pay for things
they cannot afford, governments often do the same. Whenever a government can’t pay for all
its obligations in a given year, this creates a deficit, or shortfall of money in a given
period. If a government gets more tax revenue than it needs for obligations, this creates a
surplus, or excess of money in a given period. When the government borrows money, it doesn’t
go to a bank and apply for a loan like we do. It usually sells securities to individuals,
businesses, governments of other countries, and even domestic government organizations. These
securities go up in value and can be cashed out at a later time, so the deals are usually a win-win.
For example, say you want to loan money to your government. This isn’t an act of charity,
it’s an investment. Say you buy a savings bond from the federal government. Years later,
you can cash in this savings bond with interest, meaning you made money from the purchase.
Government borrowing generally only includes borrowing from the private sector of an
economy. In most countries, the big holders of government debt hold it in pension funds,
which invest in government debt on behalf of the individual members. Whenever you hear that your
government is in debt to other countries, this is a misleading statement. Your government is in
debt, first and foremost, to individuals who are making money off the fact that governments need
more money than is coming in from tax revenue. With that said, most economists agree that too
much government debt is indeed a bad thing. Too much debt can decrease the confidence in the
currency of a country, which in turn could lead to inflation. As a national debt increases, the
likelihood of the government defaulting on its debt obligations increases. Defaulting on a loan
just means failure to pay it back. Another concern of rising debt is increasing interest rates on
government securities. If more and more people in the private sector view loaning money to a country
as risky, interest rates will go up, and in turn prices will go up. This will also cause interest
rates to go up in other lending markets as well. Economists often use the debt-to-GDP ratio as
a metric when examining whether a particular country is able to pay back its debt.
The debt-to-GDP ratio measures the ratio between a country’s government debt
and its gross domestic product, or GDP, which is the dollar value of all final goods
and services produced within a country’s borders in a given year. We will learn more about
the GDP in a future tutorial. Governments generally want to avoid having a debt-to-GDP
ratio that is more than 100%. For example, if a country’s GDP is $2.5 trillion, it ideally
shouldn’t have a debt higher than $2.5 trillion. So if the debt and deficit are too high, can’t a
government just decide to spend less money? Well, not quite. By the time most governments make
decisions on what it will specifically spend its money on, most of it is already
accounted for. In the United States, federal spending is divided into three categories:
mandatory spending, discretionary spending, and interest on debt. Mandatory spending refers
to all money that the law says is owed. A big part of mandatory spending is what’s known
as entitlements, or social welfare programs that people are “entitled to,” and benefit from
automatically once they meet certain eligibility requirements. An example of an entitlement
in the United States is Social Security, which provides aid to those who have a more
difficult time earning money through their labor. In recent years, mandatory spending has taken up
the largest share of the American federal budget. Discretionary spending is that in which American
lawmakers actually have some flexibility in determining what they spend money on. Interest on
debt is how much the American federal government must pay on its outstanding debt from previous
years. In 2022, this makes up 5% of the entire American federal budget, and that’s expected
to go up to more than 11% within ten years. In conclusion, since most governments regularly
spend more than they take in via taxes, the national debt continues to rise, especially
in recent years due to the COVID-19 pandemic. Even after the pandemic ends, demand for
government spending will likely keep increasing, and more government debt will continue to be
inevitable. At this point, the best one can hope for is that government debt remains manageable
so that economies remain relatively stable.
