Staff Paper Prepared for the President's Commission to Study Capital Budgeting

April 23, 1998
General methods

Concept and origins. OMB's estimates of depreciation are intended to measure the reduction in value of the federally financed capital stock due to aging, wear and tear, accidental damage, and obsolescence. The estimates were developed starting with the 1985 budget in order to display net investment and, starting several years later, also in order to track trends in the size and composition of the federally financed capital stock. Capital stocks are calculated using the perpetual inventory method, in which each year's stock is calculated as the stock in the previous year, less depreciation, plus new investment.

Current cost versus historical cost depreciation. OMB's measure of depreciation in the illustrative capital budgets is a current cost (or "current replacement cost") measure. It is intended to measure the decline in an asset's value in today's prices. This is in contrast to a historical cost measure, which is based on the prices of the period in which the asset was bought. Under historical cost depreciation, as used in business balance sheets and income statements, the original purchase price of an asset (less salvage value) is allocated over the estimated useful life.

Current cost depreciation is used in order to measure all activities in the budget on a consistent basis. Other outlays and receipts, including gross investment outlays, are recorded on a cash basis and are thus automatically measured in the prices of the current year. Depreciation in a capital budget system needs to be measured in the prices of the current year so that it can be compared to other expenses on an even basis. It also needs to be measured in the prices of the current year so that total receipts and outlays and the deficit are calculated on the basis of the same prices and thus measure the activities of the current year consistently.

Current cost depreciation is also used in order to obtain a valid measure of net investment. This requires that the addition to the capital stock from new purchases and the decline in the capital stock from depreciation on existing assets both be measured in the prices of the same year. If depreciation is measured in this way, a zero net investment roughly indicates that the Government can sustain the current level of services that it provides the public from its capital stock; whereas positive net investment means that the Government is increasing its ability to provide services to the public from its capital stock. By contrast, in a period of inflation, or when inflation has occurred in recent years, historical cost depreciation does not keep pace with the actual cost of replacing capital as it wears out or loses value for other reasons. Net investment measured using historical cost depreciation is overstated in terms of indicating whether and how much the Government's ability to provide services from its capital stock is increasing.

In the tables showing trends in the capital stock, OMB converts its estimates of investment and current cost depreciation into constant dollars (using a base period of fiscal year 1992). This is necessary in order to compare the quantities in different years. If either current cost or historical cost were used for comparisons over time, the measured size of investment and capital in different years would depend on the inflation rate as well as the amounts of real assets.

Methods for types of Federal investment outlays

OMB's general methods are summarized below together with some special issues. More technical details are provided in Analytical Perspectives for the 1999 budget, chapter 6, pp. 148-50, and chapter 2, pp. 36-38.

Physical capital. OMB's depreciation estimates for physical capital are based on the methods used by the Bureau of Economic Analysis (BEA), which estimates public and private physical capital stocks.(1) OMB develops separate estimates because the BEA data are not directly linked to the budget, do not extend to the years covered by the budget, and do not separately identify the capital financed but not owned by the Federal Government.

BEA revised its depreciation methods in 1996 based on further theoretical analysis and empirical research. The largest change came in the use of geometric depreciation rather than straight-line depreciation for most categories of assets. In the geometric method, depreciation each period is estimated as a percentage of the capital stock in the previous period.

The OMB database does not divide investment outlays into categories that are nearly as detailed as those used by BEA. Whereas BEA has 54 categories specifically for Federal equipment and nonresidential structures, OMB employs five categories for Federal purchases: water and power projects, other nondefense construction, nondefense equipment, defense equipment, and defense structures. OMB also employs four categories for grants to State and local governments. OMB's depreciation rates were derived from weighted averages of the rates in the more detailed BEA categories that comprised each broader category used by OMB.

Research and development. The empirical basis for estimating R&D capital stocks and depreciation is limited. OMB follows the assumptions in a 1989 study by the Bureau of Labor Statistics, in which applied research and development was assumed to depreciate at a ten percent geometric rate and basic research was assumed not to depreciate at all.(2) The OMB method assumes that federally financed R&D has the same depreciation rate as privately financed R&D.

The BLS assumptions were based on informed expert opinion. Zvi Griliches and other economists had previously studied productivity growth using R&D capital stocks as one explanatory variable. They constructed alternative capital stocks based on alternative assumptions about depreciation rates, and productivity seemed to be "explained" the best by assuming a geometric depreciation rate around 10 percent for most R&D. The BLS economist who wrote the report believes that studies performed since 1989 give added support to their assumptions.(3) In particular, some work by M. Ishaq Nadiri estimated endogenously a depreciation rate that was very close to 10 percent.

BEA used a roughly equivalent depreciation rate for applied research and development in its 1994 estimate of the stock of R&D.(4) Unlike virtually all other studies, they assumed that R&D depreciates on a straight-line basis, perhaps to be consistent with the straight-line depreciation they were still using for physical capital. They assumed a straight-line rate that corresponded most closely to a geometric rate of 11 percent, noting that "some recent studies had estimates that ranged from 9 to 13 percent per year and tended to concentrate around 11 percent."(5) Unlike BLS, they applied the same rate to basic research as well as other R&D.

Education and training. Depreciation for education and training is the most speculative of OMB's estimates. OMB arbitrarily assumes that investment in education and training depreciates on a straight-line basis over a 30-year life.(6)

Non-federally owned capital. OMB estimates depreciation not only for capital owned by the Federal Government but also for capital that is financed by the Government but owned by others. The latter category includes grants to State and local governments, universities, and non-profits to buy physical capital, and investment in intangible capital such as R&D, education, and training. Including non-federally-owned capital in a capital budget, and consequently depreciating it, raises several issues:

Alternative methods of deriving depreciation

OMB's depreciation estimates are intended to be illustrative, for the purpose of estimating rough trends in the stock of federally financed capital. If depreciation were proposed to be recognized in the budget -- e.g., through a charge to the operating budget in a capital budget framework -- the basis for the estimates might have to be much more solid.

Improvements to BEA methods. Improvements to BEA's estimates of depreciation rates would make OMB's depreciation rates more accurate. BEA's present estimates of the depreciation pattern and service lives of federally owned assets are generally based on best-guess assumptions rather than strong empirical evidence. More information would be valuable.

Financial statements. The new accounting standards for the Federal Government require general property, plant, and equipment to be reported on the balance sheet and depreciated beginning in FY 1998.(7) These data would have limitations for a capital budget. Depreciation is measured at historical cost; depreciation is allocated by the straight-line method, which is normal in financial accounting statements but is contrary to much empirical evidence that the decline in value is more accelerated and can reasonably be approximated by a geometric rate; weapons systems (and a few relatively small categories) are not capitalized and depreciated; and of course only assets owned by the Federal Government are depreciated. The quality of the initial data is uncertain.

Asset surveys. Another alternative method of deriving depreciation would be to directly assess the value of agency assets each period. Any change in value, less new investment during the period, would be depreciation. This method would be extremely time-consuming and costly, for it would require placing a current value on each item of past Federal investment.

Budgetary locus of depreciation. Depreciation might be booked as an unallocated charge to the overall budget, as a charge to each agency, or as a charge to individual accounts. If the intent of adding depreciation to the budget were solely to support a particular rule for fiscal policy, then an unallocated charge would be sufficient. However, if the intent were to recognize the full costs of agency programs, it would be necessary to allocate depreciation by agency, or some even lower level. The finer the disaggregation, the more detailed the method would have to be, to recognize the differences in the investment undertaken by different agencies and the resulting depreciation.

1.  See Arnold J. Katz and Shelby W. Herman, "Improved Estimates of Fixed Reproducible Tangible Wealth, 1929-95," Survey of Current Business, May 1997, pp. 69-92; and Barbara Fraumeni, "The Measurement of Depreciation in the U.S. National Income and Product Accounts," idem, July 1997, pp. 7-41.

2.  BLS Bulletin 2331, The Impact of Research and Development on Productivity Growth (September 1989), pp. 3-4 and 7-8.

3.  Conversation with Leo Sveikauskas, April 21, 1998.

4.  "A Satellite Account for Research and Development," Survey of Current Business (November 1994), pp. 37-71. Depreciation is discussed on pp. 44-45 and 58.

5.  Ibid., p. 58.

6.  OMB estimates the stock of education using a different method. The stock is estimated as the Federal share of the replacement cost of the years of education embodied in the U.S. population 16 years of age and older. This method does not readily permit decomposition into new investment and depreciation. OMB does not estimate the stock of training capital.

7.  Statement of Federal Financial Accounting Standards No. 6, Accounting for Property, Plant, and Equipment.

President's Commission to Study Capital Budgeting