Monday, July 11, 2011

How Government Finance Works

I have said many times that there 's "no such thing as a free lunch."  What I've neglected to do is explain how government finance works -- that is, how does government get the money to spend it on programs and so on.  Note that this is somewhat of a simplification, and I am not an expert on this subject, but I believe what I am saying here is true.  If anyone has any better first-hand knowledge, please pass it along!

Let's start with a simple example of how you would handle things in your own household.  Let's say you want to buy something - a big screen TV for example.  You have several options:
  1. If you have the cash, and it is not earmarked for some other expense, you simply pay for it.  You're done.  The other options below mean you don't have the cash available, so you need to get the money some other way.
  2. Charge it on your credit card.  Doing this means you get the TV, but you will be paying much more for the TV since you will need to pay back the credit card company with interest.  Paying minimum payments on your credit card means that the TV you purchased will cost more than twice as much as you paid.
  3. Borrow money from a family member.  Family generally doesn't charge as much (if any) interest, but not paying the amount back in a reasonable amount of time means that you will not be on good speaking terms any longer with your family (and they could sue you in court).
  4. Sell something of value you already own and don't use.  There's eBay, amazon.com, and even pawn shops.
  5. Perhaps you live with someone and you could both pool resources and share the TV.  This doesn't happen too much anymore.
  6. Don't purchase the TV now, and save for it.
  7. Steal the money.  No, I don't recommend this option, and it really isn't an option, although people do it.
If you were fiscally-responsible, you would first think about whether the TV is something you really needed at this time, and consider whether it was necessary to finance it or simply wait until you had the money to pay for it.  A TV is typically a discretionary expense, meaning you can live without it (it is something you'd just like to have).

Likewise with something more important and much more expensive, like a house.  Most people have no other alternative than to take a mortgage (a loan) to buy a home, which tends to be not quite as discretionary (how large/small and expensive of a house is, though).  That money does come with a large cost, though.  A $100,000 house with a 10% down payment at 5% interest goes a little like this:  You'll need about $15,300 at closing, you will owe $90,000 and pay around $800/month (principal+interest+taxes+insurance).  After you pay the house off in 30 years, the $100,000 home you purchased will really have cost you $183,930.21.  Consider also that if you don't stay in the home for the full 30 years, be aware that the way compound interest works is that you end up paying more interest than principal at the beginning of the loan (in order to keep a consistent payment throughout the loan's lifetime).  I know this because I have a handy spreadsheet around for just this kind of thing.

Some of you already know all this, and I'm sorry I had to explain this in detail.  However, there are some people who miss the fine points of personal finance, which is a prerequisite to understanding municipal and federal finance.

In government finance there is income and expenses, just like in personal finance.  Unlike personal finance, government does not have the means to earn money (they could print money arbitrarily, but that would cause the money to become worthless).  If a government wants to build a bridge, for example, that costs $10,000,000 to make, it needs to do one of the following:
  1. If there are funds in reserve -- that is, money in the government's savings account -- and enough to build the bridge, then the government procures a contractor and construction begins.  Because people in government don't seem to understand finance too well, they don't have money in reserve these days...
  2. It can raise taxes proportional to the amount of the bridge in order to raise funding.  This is a problem, though, because the properties of inflation means that the bridge will likely cost more by the time enough money is raised through taxes to build the bridge.  Also, if the bridge is needed right away, waiting until enough tax revenue is raised may be too long.  Also, assuming that the bridge would be built using 1 year's worth of taxes, it is very likely that this would become an unreasonably large tax burden for most people.
  3. It can sell a bond to acquire the funds to build the bridge (doing this at the municipal level generally requires an election).  This is the usual way that governments obtain funding for a project.
  4. It can steal the money.  I don't recommend that government steal money either, but in some instances this actually does happen, sadly enough.
A bond is where the "national debt" comes from.  Remember "savings bonds?"  This is an example of a government bond.  The government sells bonds with a promise to pay back the principal and a certain amount of interest when the bond matures, or comes due for payment.  At that time, whoever holds the bond can cash it in and the government pays the holder (principal+interest).  In essence, the government is borrowing money from its own people, foreign interests, and so on, just like you would if you borrowed on a credit card or took out a mortgage.  Only in this case, whoever the bond holder is (maybe even you) is the one extending credit.

How does the government get the money to pay the holder of the bond?  They get that through levying taxes.  Generally bonds take 10 years or more to mature, so the principal and interest can be divided up over 10 years, so that taxes won't need to be raised so high that the cost of the bridge would represent an undue tax burden.  In short, the government takes out a loan for the bridge, and we, the people, pay back that loan.

What happens if the government can't pay on their debt?  Well, then, we're in a bit of a pickle, aren't we?  See, the government doesn't earn money, and they don't have stuff they can sell-off on eBay or at a pawn shop.  Worse still, the people who mismanaged the funds to begin with (our elected representatives) are generally long gone, or if not, they're not going to own-up to the fact that they screwed-up.  Or, maybe they haven't screwed-up, but perhaps something cost more than they expected.  Much more.  Either way, the government has to pay on their debt or they default on their loans and go bankrupt.  Since we, the people, are technically the government, that's not a good situation for us.

So what the government usually ends up doing is taking out a new loan to pay the other loans.  Since the government is typically a pretty good "customer," they usually don't have any trouble finding a new entity willing to loan them money.  Remember, though, that just like your own finances, if you pay one loan with another loan you not only pay interest on the original amount, but now you're paying interest on the outstanding balance of the loan plus the interest.  Over time and enough screw-ups, that comes out to a boatload of interest.  The other problem is that governments who have a reputation of being like Bernie Madoff really can't sell bonds after a while, if the prospective bond holders don't think the government can pay it back.  So at some point, funding though tax revenues does have to happen or eventually they'll be so "upside-down" on their loans they won't be able to get more!

This is the reason why there is no such thing as a free lunch.  Eventually, every government program or expenditure requires that we, the people, pay it back.

Senator John Cornyn was recently quoted as saying that 51% of American households pay no income tax.  Let me repeat that:  51% of households in the United States of America are not paying income tax.  When people start bellyaching about the rich not paying their fair share of taxes, I would like you to consider this number.  If the 51% of American households that didn't pay income taxes received no benefit from the programs and infrastructure that the government procured, then perhaps I would feel better about this.  However, what this really means is that 49% of us - that is, the rest of us - are paying for all the stuff that the government did and are doing for all of us that hasn't been paid for yet.  That figure is both astounding and distressing.  While I am in agreement that corporate tax loopholes need to be closed, I also feel that this is a good time to start considering a flat tax.  People cannot be asking for and consuming resources without paying for them, and that is exactly what is happening now.  Municipal governments are increasingly in crisis trying to pay their debts.  The U.S. federal debt is now over 10 trillion dollars, and has no end in sight.  In fact, this is what raising the debt ceiling is all about.  It's not just about what the federal government is spending, but really more about how much they've borrowed and how much they haven't yet paid back.

This is the reason why I tend toward being fiscally conservative (no, not Republican, I mean fiscally conservative, or even better, fiscally responsible).  As a society, we need to start understanding the cost of what we want, and carefully consider that cost against the benefit we receive.  If this were your own household, and you were at least half-way financially responsible, you would not keep spending and spending and increasing your debt while having no way to pay it back.  That is what the government has done, and with the financial climate as it is right now, the implications of our debtors asking for their money and government not having anyone to sell bonds to makes this even more dire.

I don't want to pay higher taxes, but even more so, I don't want to pay higher taxes while more and more people who consume more of the resources the government provides pay none.  Not only is that not fair, it is, in my opinion, criminal.  Yes, I agree that there are issues with health care and so on, but consider what will happen if you tax the doctors and health care providers right the heck out of this country.  Then what?  What happens when all the people who are innovating and making something for themselves leave the United States because they pay so much in taxes that their efforts are no longer fruitful?  I'm not sure you want to think about that.

Again, I am not in favor of "tax cuts for the wealthy," but I'm also not in favor of 51% paying no taxes.  I'm not in favor of someone with 3 kids, a big house, a big shiny new car, and all the crap they buy for themselves and their kids, telling me how they want need a tax cut and asking why the rich are getting a tax cut.  How they want this program and that program to be funded by "the government."  We don't have any more money, and we can't afford to be giving tax cuts to the people who use the stuff the government (really us) pays for.  We have to start being responsible, and if we don't, there soon won't be any government-funded programs and infrastructure.  At all.  Maybe not even a government.

1 comment:

Interceptor said...

While not as relevant to your comments as would be wholly appropriate, I find that looking at the actual numbers is very informative. Listening to the media and politicians say what is happening, I would assume very different debt numbers and their relative changes over time than what has actually occurred.
http://presidentialdebt.org/