How Does the Government Make Money?
The primary way that the United States government makes money is through taxation. In Section 8 of the first article of the Constitution, the U.S. Congress is afforded the right to assign and collect taxes. There are several sources of tax revenue. The breakdown of the federal government’s tax income is as follows:
- 45% comes from individual income taxes
- 39% comes from Social Security and Medicare taxes
- 12% comes from corporate income taxes
- 4% comes from estate, gift, and other miscellaneous taxation
It should be noted, however, that because half of Social Security and Medicare taxes are taken directly from an individual’s income, it means that the government obtains 65% of its tax revenue from individuals.
- The government primarily generates revenue through the imposition of taxes – individual income taxes, Social Security/Medicare taxes, and corporate taxes.
- The government also generates revenue through issuing debt instruments such as Treasury bonds, Treasury bills, and Treasury notes – securities with varying rates of maturity.
- One less traditional method of generating income is the imposition of the so-called “inflation tax,” when the Federal Reserve simply prints more money.
The government must generate enough money each year to cover its expenses, as outlined in the yearly budget. As previously noted, it seeks to accomplish its objective primarily through the collection of taxes. If the government collects more in taxes during the year than it needs to meet its expenses, then the country posts a budget surplus. If, however, the collection of taxes does not cover annual expenses, then the federal government runs a deficit.
It is important to note that the U.S. government has run a deficit – which is typically equal to approximately 3% of the overall economy – for the past 45 years, which is roughly since the time that former President Richard Nixon took the country off the gold standard. The abandonment of the gold standard and the Bretton Woods Agreement in 1971 was followed by hyperinflation by the end of the decade.
Running a deficit at the federal level is nearly a given as of 2020, thanks largely to the massive federal debt. The debt doubled in size under former President George W. Bush (from $5 trillion to $10 trillion) then doubled again under former President Barack Obama (from $10 trillion to $20 trillion). As of 2019, servicing the national debt – just making the interest payments – required more than half a trillion dollars (approximately $590 billion).
During particularly rough years – such as during the Global Financial Crisis of 2008 (and most likely what’s shaping up to be the recession of 2020) – government spending increases in order to cover need-based programs, such as unemployment benefits, Medicaid, and food stamps. During a recession, the government typically collects less in total tax revenue because individuals are working fewer hours and, therefore, paying less in income taxes.
To cover any shortfall, the government generates revenue through debt – borrowing money by issuing financial instruments, such as Treasury bonds. The bonds are effectively risk-free ways for individuals, institutions, and other countries to diversify their investment portfolios, while at the same time, helping the government facilitate its spending.
There are four primary debt instruments at the disposal of the U.S. government. In addition to Treasury bonds, it may also use Treasury bills, Treasury notes, and Treasury Inflation-Protected Securities (TIPS).
The largest holder of U.S. securities is Japan, which overtook now second-place China in 2019. As of the end of 2019, Japan held approximately $1.2 trillion in U.S. Treasuries. The other primary holders of U.S. Treasury securities are – in order – China, the UK, and Brazil.
The “Printed Money” Tax
There is another less traditional method available to the U.S. government for generating revenue – the Federal Reserve essentially just prints more money! But how does it generate revenue? Consider that before 1933, the U.S. economy was based on the gold standard– the government couldn’t just print currency at will. It could only produce cash approximately equal to what it held in physical gold, as all Federal Reserve notes were, at that time, redeemable for gold.
That limitation on the government’s ability to print money was effectively removed when former President Nixon abandoned the gold standard. Now, the government can implement an inflation tax. As the Federal Reserve prints more money, expanding the money supply, it results in inflation, which decreases the purchasing power of each U.S. dollar. It is true for the physical bills in a person’s wallet or the money in an individual’s bank account.
The government prints money to purchase things and, in doing so, decreases the value of the money that each individual possesses. It means the government has basically taxed the individual for items that it had printed money to pay for.
The Crash of 2020
The Economic Crash of 2020, brought on by the coronavirus pandemic, has led to an unprecedented amount of money being printed by the Federal Reserve. As of May 1, 2020, the U.S. government’s financial aid and rescue programs related to the pandemic had already surpassed the previous year’s entire budget of $4.4 trillion. Many economists fear that the Fed’s massive expansion of the money supply may eventually lead to runaway inflation.
We hope you have enjoyed reading CFI’s explanation of How the Government Makes Money. CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. The following CFI resources will be helpful in furthering your financial education: