Understanding the Federal Budget
The federal budget is more than just a set of numbers. It expresses the policy priorities of our nation — and is a critical part of our fiscal and economic future.
The federal budget reflects our elected leaders’ decisions on how to tax and spend, to borrow and lend, and to consume and invest. Those decisions define the size of the federal government and its role in the national economy.
Federal Spending
In 2023, total federal spending was $6.1 trillion — nearly 25 percent of the size of our economy and $18,300 for each person living in the United States. That spending can be divided into three categories.
1) Mandatory Spending
Programs governed by provisions of permanent law are referred to as “mandatory.” Because these mandatory programs are written into law and do not require annual approvals, this spending is essentially on “autopilot” unless policymakers change the laws governing the program.
Many of the programs that provide benefits to individuals are classified as mandatory spending, including Social Security, Medicare, and Medicaid. Those programs are also often referred to as "entitlements" because individuals who meet the programs’ eligibility requirements are "entitled" to benefits.
Mandatory spending covers programs in six major areas:
- Major Health Programs refers to four programs: Medicare (for seniors and disabled people); Medicaid (generally for lower-income beneficiaries); premium tax credits and related spending (for low- and moderate-income people); and the Children’s Health Insurance Program (CHIP, for low-income children and parents).
- Social Security provides payments to retired and disabled workers, as well as to their spouses, dependent children, and survivors.
- Income Security Programs make payments to individuals based on their income through programs including: earned income, child, and other tax credits (refundable tax credits for the working poor); the Supplemental Nutrition Assistance Program (SNAP, formerly known as food stamps); Supplemental Security Income (payments to disabled children and adults with limited incomes); unemployment compensation (time-limited payments for people who become unemployed); family support and foster care; and child nutrition.
- Federal Retirement Programs for federal civilian and military retirees.
- Veterans’ Programs that provide pensions, income support, and other benefits for those who previously served in the military.
- Other Programs consist of a range of programs, including agricultural subsidies, student loan subsidies, and deposit insurance.
The laws governing mandatory programs do not provide specific funding levels. Instead, they specify who is eligible for benefits as well as the type and level of benefits that each person can receive. For example, the unemployment insurance program has eligibility criteria regarding employment status, availability to work and past income that, once met, allow an individual to receive a certain level of benefits. Total federal spending on the program in the budget depends on the number of people who file for unemployment, not on a fixed amount of funding set by lawmakers.
The term "mandatory" doesn’t mean that lawmakers are powerless to alter this spending. At any time, elected officials can adjust the eligibility criteria and benefit formulas that determine spending on mandatory programs, as they did with Social Security in 1983. However, if Congress and the President take no action, the current formulas and criteria for benefits generally remain in place year after year, and the spending flows as specified by law, without interruption.
Over time, federal spending for mandatory programs has increased more quickly than most other programs — primarily because of the growth in Social Security, Medicare, and Medicaid. Around 50 years ago, around 40 percent of the federal budget was spent on mandatory programs, while the rest funded an array of discretionary programs and net interest. CBO estimates that around 60 percent of federal spending currently go to mandatory programs.
2) Discretionary Spending
Discretionary spending is determined on an annual basis by Congress and the President through the appropriations process. As opposed to the "automatic" nature of mandatory spending, discretionary spending must be reviewed and approved each fiscal year.
Defense spending represents nearly half of total discretionary spending. Other major activities funded through appropriations include homeland security, education, transportation, research, food safety, science and space programs, disaster assistance, environmental protection, public housing, and federal law enforcement.
In the 1960s, about 67 percent of total federal spending went to fund discretionary programs. In 2023, discretionary spending was just 28 percent of the budget. Over the next decade, it is projected to decrease to a historically low level relative to the size of our national economy.
3) Net Interest
The third major category of spending is interest on the national debt. Interest rates have been relatively high for the past couple of years due to high inflation and actions by the Federal Reserve. Driven by those rates and the accumulation of federal debt, interest costs have become the fastest-growing “program” in the federal budget — exceeding the rate of growth of both Social Security and Medicare. Currently, the United States spends more than $2.4 billion every day on interest payments. Over the next ten years, the Congressional Budget Office (CBO) estimates that interest costs will total $12.9 trillion, and looking further ahead, CBO projects that net interest costs will grow from 11 percent of the budget in 2023 to 23 percent in 2054.
Federal Revenues
In 2023, total federal receipts were $4.4 trillion, about 16.5 percent of gross domestic product (GDP). The largest sources of federal revenues are the individual income tax and payroll taxes, followed by the corporate income tax, customs duties, and excise taxes.
Individual Income Taxes
The federal government collects taxes on the wages and salaries earned by individuals, income from investments (for example, interest, dividends, and capital gains), and other income. Individual income taxes are the largest single source of federal revenues, constituting around one-half of all receipts. As a percentage of GDP, individual income taxes have ranged from 6 to 10 percent over the past 50 years, averaging around 8 percent of GDP. Tax liabilities vary considerably by income. In 2019 (the most recent year for which data are not affected by temporary distortions resulting from the COVID-19 pandemic), the top quintile of earners paid 84 percent of all individual income taxes, while people in the two lowest income quintiles had negative income tax liabilities (that is, on average, they received more in refundable tax credits than they owed in income taxes). However, all earners pay payroll taxes, as described further below.
Payroll Taxes
Both employers and employees contribute payroll taxes, also known as social insurance taxes. Payroll taxes are the second-largest component of federal revenues and account for approximately one-third of total tax receipts, or approximately 6 percent of GDP. Payroll taxes help fund Social Security, Medicare, and unemployment insurance. For Social Security, employers and employees each contribute 6.2 percent of every paycheck, up to a maximum amount ($168,600 in 2024). For Medicare, employers and employees each contribute an additional 1.45 percent, with no salary limit. The Affordable Care Act added another 0.91 percent in payroll taxes on earnings over $200,000 for individuals or $250,000 for couples. Employers also pay the federal unemployment tax, which finances state-run unemployment insurance programs.
Corporate Income Taxes
The government collects taxes on the profits of corporations. In 2022, most corporate income was taxed at 21 percent at the federal level (before adjustments). When combined with state and local corporate taxes, the average statutory tax rate was 25.8 percent, although most corporations pay less than the statutory rate because of exemptions, deductions, and other adjustments to income. Corporate taxes amount to approximately 9.9 percent of all tax revenues, or approximately 1.6 percent of GDP.
Excise Taxes
Taxes on certain goods such as tobacco, alcohol, and motor fuels also contribute to federal revenues. Those excise taxes are imposed at the point of sale and add to the prices that consumers pay for such goods. Revenues from excise taxes amount to approximately 2 percent of all tax revenues, or approximately 0.3 percent of GDP.
Customs Duties
The government collects revenues from duties and tariffs on imports. Those revenues amount to approximately 2 percent of all tax revenues, or approximately 0.3 percent of GDP.
Other Revenues
Federal revenues that come from other sources — such as estate and gift taxes and the deposit of earnings from the Federal Reserve System, among others — amount to approximately 2 percent of all tax revenues, or approximately 0.3 percent of GDP.
Who Pays Taxes
To evaluate whether the tax system is fair or not, it is important to look comprehensively at all of the taxes that people pay, not just one particular form of taxation.
For example, while it is true that many lower earners pay little or no individual federal income tax, there are many other kinds of taxes that apply to such individuals. In fact, taxpayers whose incomes are in the bottom 90 percent of all incomes pay, on average, more in payroll taxes than in income taxes. At the other end of the spectrum, high-income Americans receive a significant amount of their income from capital gains and dividends, which are taxed at lower rates than wages and salaries. However, wealthier taxpayers also face higher tax rates on their other income and indirectly bear a greater share of the corporate income tax, which significantly raises their overall effective tax rates. In the aggregate, our federal tax system is structured to be generally progressive, with higher-income taxpayers paying a larger share of their income in taxes.
Tax Expenditures
The income tax code contains many provisions that allow individual and corporate taxpayers to effectively reduce their tax bills. Such special provisions — deductions, exemptions, deferrals, exclusions, credits, and preferential rates — are known as “tax expenditures.” In 2023, tax expenditures totaled nearly $1.8 trillion. That amount equals nearly 70 percent of the revenues that the federal government actually collected in income taxes and exceeds what was spent by any single agency or spending program, including Social Security and the Department of Defense.
Just eight tax expenditures amounted to $1.1 trillion in 2023 — more than half of the cost of all tax expenditures.
Tax expenditures are often referred to as "spending in disguise," because lawmakers use the tax code to direct subsidies to specific constituencies and activities. Policymakers also use tax expenditures to influence consumer and business behavior. The mortgage-interest deduction, for example, encourages taxpayers to buy homes instead of renting. Similarly, depreciation provisions for businesses encourage new purchases of equipment. In addition, because tax expenditures subsidize "favored" activities, they can distort economic decisions in ways that reduce the productivity of our economy.
Tax expenditures generally receive less scrutiny than spending programs. Most do not need annual review and approval, and therefore often remain in place for many years. With few opportunities for review and consideration, they are harder to control and less transparent than line-item spending programs. Many tax expenditures are also more valuable for people at higher marginal tax rates, so the benefits of tax expenditures often skew toward those with higher incomes.
The Budget Process
Policymakers use the federal budget process to establish spending priorities and to determine who will pay for those activities. The formulation of the budget is an annual process that involves the Congress, the White House, and federal agencies.
Within the process, lawmakers do not approve one single budget — the federal budget comprises many separate documents and pieces of legislation.
The President’s Budget
One of the important budget process documents is the President’s annual budget proposal, which lays out the Administration’s budget priorities in detail. The Congress has never voted to accept the President’s budget in its entirety, but it acts as a starting point for discussion. The President is required to submit a budget to Congress by the first Monday in February every year, but in practice the submission often occurs after that date.
Budget Resolutions
Congress has its own budget process: The House and Senate are each supposed to prepare a budget resolution that serves as a broad framework for the many separate pieces of legislation that will determine spending, revenues, deficits, and debt. The two sides of Congress are then supposed to reconcile their separate plans to agree on a concurrent resolution by April 15 of each year. Because funding can be provided through other means, a budget resolution is not necessary for the annual budget process to occur. In fact, sharp disagreements about fiscal policy have either prevented Congress from agreeing on an overall budget plan or delayed the passage of the resolution in several of the past years.
Appropriations
The Appropriations Committee in each chamber writes the legislation that actually provides government agencies and programs with money to spend on discretionary programs. All appropriation bills must be passed by the end of each fiscal year (October 1). If Congress fails to meet that deadline, it must pass a “continuing resolution” to enable funding to continue, as discussed below.
Reconciliation
The budget resolution can also include "reconciliation" provisions that instruct the various authorizing and tax committees to draft legislation that adjusts — or reconciles — revenue and spending levels to meet those established in the budget resolution. Reconciliation can be a powerful vehicle for passing legislation because the amount of time allowed for debate of a reconciliation bill is limited once it reaches the floor of the House and Senate. This is a particularly important provision in the Senate, because it allows lawmakers to avoid a filibuster, which otherwise could indefinitely prevent passage of legislation until 60 members vote to end it.
Continuing Resolution
When appropriation bills are not enacted by the start of the fiscal year, Congress often uses a continuing resolution (CR), as a temporary measure to fund government activities for a limited amount of time. CRs are “stopgaps,” often employed to avoid a partial government shutdown. CRs should be rarely used, but they have become the norm over the past few decades.
Budget Process Reforms
The current budget process faces a number of challenges and is ill-suited for managing the nation’s long-term fiscal outlook. There are a range of potential reforms that could improve the budget process and fiscal outcomes.
While budget process reform alone cannot substitute for political agreement about fiscal policies and priorities, there are many reforms that would help encourage responsible budgeting and improve accountability. Areas of reforms include:
- Adding a long-term focus. The current budget process is focused on a 10-year “window” that Congress uses to measure the projected effect of lawmakers’ actions going forward. This window could be extended for a longer period, to better focus on key long-term drivers of our growing debt.
- Setting targets. Requiring Congress and the president to set medium- and long-term fiscal goals, then reporting annually on the progress they have made toward those objectives.
- Strengthening enforcement. Adding new or strengthening existing enforcement measures that would help policymakers stay on the path towards their budget targets. These reforms should be flexible enough to accommodate changing economic conditions and priorities, but, at the same time, be strong enough to establish and reinforce overall commitment to fiscal sustainability.
- Other reforms. There are a number of budget process reform options frequently discussed by policymakers, such as changing the congressional budget resolution into law or adopting a biennial budget process.
While the annual budget process would benefit from reform, there are fundamental problems caused by the lack of political will to make difficult choices. Without effective decision-making about fiscal tradeoffs, deficits are projected to rise to unsustainable levels in coming decades due to the aging of the population, rising healthcare costs, increasing interest costs, and insufficient revenues to meet existing commitments. Improving our fiscal condition over the long term will take political leadership from both parties.