OVER THE PAST two decades the federal budget has grown dramatically. Even after accounting for inflation, the government now spends more than two and a half times as much as it did in 1960, and it spends those dollars on a different combination of purchases. Back in 1960, almost half the budget was spent on defense. Defense spending has substantially outpaced inflation since then, but other parts of the budget have grown faster still.

Has the federal budget gotten too big? The question always comes up at this time of year when the president presents his budget proposals. To answer it, you need to examine what the country is now buying with its tax dollars and how else it might prefer to spend these dollars. Defense expenditures are a real and growing claim on the nation's productive capacity. Whether that claim is too small or too large depends upon how you assess the size and intensity of threats to the nation's security. Almost half of the budget, however, doesn't directly buy either goods or services. Instead, it simply transfers money collected from taxpayers to people who meet certain conditions of eligibility to receive it.

Roughly one out of four of these "transfer" dollars is earmarked for people with low incomes, much of it for medical care. The remaining three-fourths is roughly analogous to insurance payments--returns paid to previous contributors who are now old, sick or unemployed. These payments have grown very rapidly over the last 20 years partly because the population is aging, but also because the society has found it convenient and desirable for the government to provide this kind of protection.

There is no magic number that determines the proper level of government spending. Whether you think government expenses are too high or not depends to a large extent on how you prefer to pay for many services--through the tax system or out-of- pocket. Would you rather pay more for private pensions and medical coverage and less for Social Security? Would you rather commit your free time and money to helping poor kids or pay for professional help? Would you rather take care of your aging mother or infirm aunt yourself or have the government do it? Choosing the do-it-yourself approach might stimulate private saving and investment, but it also might leave you paying a lot more for much less adequate services and secure protection.

The United States devotes considerably less of its income to social spending than most of its more prosperous allies. Among the major industrial nations, only Japan spends less, and that's partly because Japanese companies provide a great deal more security for their workers than do most U.S. firms. Some of the more social-minded countries, such as Sweden, are, however, feeling strained and have begun to reconsider their past commitments. The Reagan administration has called upon this country for a similar re-examination. That's not a bad thing to do, but it's important to start off the process with a clear understanding of what's at stake.