Issues facing the public sector are not unlike some issues facing America’s oldest and largest companies, just on a broader scale. Each budgetary decision that is made impacts various sectors of society that rely on governmental programs. Some programs are guaranteed, while others are not when there are tough economic decisions to be made. The effects of budgetary constraints are felt on those programs considered “discretionary”.

The public sector is that part of the economy controlled by the government. Elemental services include infrastructure (e.g. roads), healthcare for the poor and aging (e.g. Medicaid/ Medicare), public transit, the police and other defense agencies, and public education. These services are subjected to the annual budget process. At any point in time many of social services can be sacrificed when budgetary constraints force cuts. To understand this process better, we put together a simplified financial example of a sample government and the choices it faces.

Example: Government XYZ Revenue Sources

Government XYZ has only a few sources of revenue, the majority of which come in the form of taxes. Individual income taxes and payroll taxes generate the most revenue. Corporate income taxes, excise taxes, and other taxes (such as gift or estate taxes) bring in the remaining tax income. Income from earnings on investments, customs/duties, and fees or charges for other receipts make up the remaining small portion of revenues. Any change to these sources, such as when businesses move to a different region or its residents’ incomes decline, results in a decline in Government XYZ’s income. The only way to make up a shortfall is to either raise taxes or decrease spending. Raising taxes is never a popular move and Government XYZ, especially during a recession or other difficult period, tries to avoid this tactic. The other course of action, decreasing spending, becomes the default option. 

Example: Government XYZ’s Mandatory Obligations

Government XYZ has many obligations, some that are discretionary and others that are mandatory. The annual level of mandatory spending, often referred to as entitlement spending, for programs such as public healthcare, retirement benefits, and food subsidies, depends on recipient eligibility compared to discretionary spending which is re-authorized annually. Participation in these programs is on a qualified basis, but Government XYZ is required to provide the appropriate level of benefit for all qualified participants, an expenditure that could result in a staggering percentage of its revenues. To eliminate or drastically reduce these programs would require a change in laws, a difficult prospect for Government XYZ.

In addition to the public healthcare, retirement, and food benefits, Government XYZ is mandated to provide funding for its workers’ pension plans, healthcare, salary, and other benefits. These obligations are no different than the ones faced by large, traditional companies in the United States. Shortfalls in pension funding and retiree healthcare have become a huge source of strain on many longstanding companies. Pension shortfalls arise from several legacy predicaments. Companies with current or residual defined pension plans have felt the burden of funding mismatches as the number of retirees have outnumbered the number of current employees paying into the plan, and the assumed hurdle rates (the expected return from the market) have not met expectations. Government XYZ will have to contribute to the pension plan to make up the difference. Now this is not always been the case. In years with strong market returns, funded status can improve dramatically, but Government XYZ needs to budget for more consistent contributions so that year-to-year these liabilities do not get too far out of hand. There is a similar dynamic with retiree healthcare benefits. 

Example: Government XYZ’s Discretionary Obligations

Discretionary spending is the portion of the budget that Government XYZ’s leader requests and the other members of Government XYZ approve (or appropriate) every year. Discretionary programs include military and defense, education, food and farming, highway and infrastructure, and courts. Aid to other governments is also captured in this bucket. Spending for these programs is the focus of many contentious debates, and the consequences on the citizens of XYZ are palpable and pervasive. 

Example: Government XYZ Budgetary Constraints--A Domino Effect

The results of budgetary constraints or windfalls are only felt in the discretionary spending programs unless new laws are enacted that would change mandatory obligations. To see the impact of decisions by Government XYZ on its residents, let’s look at an example of a constraint. Government XYZ votes to eliminate highway and infrastructure spending. The effect of these cuts has a positive impact on Government XYZ’s finances, as it no longer spends money on these programs. But a negative impact is felt by many: the companies who manufacture and sell highway construction equipment, the suppliers of highway material, the construction workers who no longer have a job to build highways, the restaurants near the construction site who provide food to the workers, and so on down the chain. This one decision to eliminate a budgetary item has had a strong, spider web-like, negative outcome on so many facets of XYZ’s society. 

On the other hand, when budgetary windfalls occur, Government XYZ decides to increase farming subsidies so farmers can invest in better technology to improve growth yields. There is a negative impact on Government XYZ’s finances, but a positive outcome is felt by many: the farmers who receive income from the government to improve yields, the farming equipment manufacturers who sell new equipment, farming seed and soil companies who sell their services and goods to improve yields, and so on. There may be a shift in the labor component—new technology may replace the number of manual laborers required—but that may mean more employment opportunities for skilled technology workers. The long-term impact from the increase in discretionary spending on farming subsidies is lower food prices for consumers, who are then able to take that money saved and spend on other areas of the economy (creating more tax revenue). 

The Bottom Line

The public sector needs to address the needs of numerous, diverse constituents. It is often faced with conflicting decisions on how to best spend a finite level of income on an almost infinite potential set of programs. Sometimes revenues cover or exceed expenses and sometimes they don’t. During periods of constraint, the government makes decisions on which discretionary programs it will pay for, reduce, or end. Sometimes it may feel like a “robbing Peter to pay Paul” decision with widespread impacts through many layers of society, and the negative externalities can have some unintended consequences. 

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