Restructuring the Federal Budget
 
 
 
 
 
 
 
 
 
 
 
 
Testimony Prepared for the
President's Commission to Study
Capital Budgeting
by Letitia Chambers
September 16, 1998
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 
 
 
 
 
 
 
 


Restructuring the Federal Budget
Testimony by Letitia Chambers1
TABLE OF CONTENTS
PART I. The Current Federal Budget Structure Prevents Full Public Debate About  
  Investment Spending Priorities and Their Impact on the Economy Page 1
  -    Short-Term Focus
  -    Overview of a Restructured Budget
PART II. Capital Investment Budget Page 4
  -    Physical Capital Investment - Defense Related
  -    Physical Capital Investment - Civilian
  -    Research and Development (R&D) Investment
  -    Human Capital Investment - Education and Training
  -    Other Human Capital Investment
  -    Direct and Guaranteed Loans
  -    Summary of Programs and Funding Included in the Capital
        Investment Budget
  -    Financing a Capital Investment Budget
  -    Implementing a Capital Investment Budget
PART III. Investments in and for Current, Future and Retired Workers Page 19
  -    Using Retirement Funds and Unemployment Insurance to Mask Deficits
        Distorts the Purposes of the Programs
  -    Unified Budget Understates Operating and Interest Expense
  -    Proposed Federal Budgetary Treatment of Pension and Other Income
        Replacement Funds
  -     Accounting Treatment for Trust Funds in the Pension, Income
         Replacement Budget
  -     Budget Estimates for the Pension, Income Replacement Budget
PART IV. Summary Budget Presentation Page 26
 

(Note: The page numbers above correspond to the original document and may not correspond to this Web version.)

Acknowledgments: The author wishes to acknowledge and thank Craig E. Bury and Dr. James A. Rotherham for their assistance in the development of the concepts set forward in this paper and in the budget tables included.

1 Dr. Letitia Chambers is President of Chambers Associates Incorporated, a public policy consulting firm. Her long years of public service have included executive positions in state and local governments; and service as Senior Policy Analyst on the first staff of the Senate Budget Committee; Staff Director of the Senate Committee on Labor and Human Resources, and earlier of the Senate Special Committee on Aging; Chief Budget Advisor to the Clinton/Gore transition, where she worked on early drafts of the President's economic plan; and U.S. Representative to the United Nations General Assembly in its 51st session.


PART 1.    THE CURRENT FEDERAL BUDGET STRUCTURE PREVENTS FULL
           &nbs p;       PUBLIC DEBATE ABOUT INVESTMENT SPENDING PRIORITIES
           &nbs p;       AND THEIR IMPACT ON THE ECONOMY

Short-Term Focus

Although the President's budget request and Congressional budget resolutions include future projections of anticipated spending and revenue, the budget focuses primarily on the pending fiscal year, which is called the budget year. This preoccupation with the budget year leads to many short-sighted decisions designed to keep spending down in the budget year, even at the expense of higher outlays in the out-years.

This focus on immediate spending decisions rather than the long-term costs and benefits of government activities has led to an under-investment in areas that could stimulate economic growth. The decline in spending for infrastructure is a prime example. Table I shows the Federal spending for major capital investment as a percentage both of total Federal spending and of GDP.
 
Table I 
Federal spending for non-Defense major physical capital investment as a percentage of Gross Domestic Product (GDP) 
 
Fiscal Years
As a Percentage of Federal Spending As a Percentage of GDP
1961-70
5.49 1.04
1971-80 5.23 1.06
1981-90 3.80 0.86
1991-98 4.15 0.85
 
Source: Budget of the United States Government: Fiscal Year 1999, Historical Tables, Table 9.3, p 148.
 
Table I shows that our infrastructure investment was a fairly constant percentage of GDP during the 1960 and 1970's, but dropped significantly in the 1980's and 1990's. This decline occurred despite the well documented need for increased spending in this area, estimated in the mid 1980s by the Congressional Budget Office at a shortfall of $240 billion by the end of this century.

The treatment of federally- financed physical capital as a current expense distorts economic decision-making. The future productive capacity of the American economy depends to a significant degree on the availability of adequate public facilities. Rebuilding, revitalizing, and expanding public infrastructure is imperative for future growth. An impediment to adequate funding for infrastructure investment is the lack of a federal capital budget.

Future productivity growth is also directly related to expenditures for research and development. The transition to a post-Cold War economy requires that we rethink the role of defense in the Federal budget. To a significant extent, the technological advances in the past half century have come out of defense: communications intelligence spurred development of automatic data processing, military aviation enabled commercial jet aviation, and avionics spawned solid state electronics. As the U.S. down-sizes the military establishment, policy makers must give consideration to the role that such technological advances have played in strengthening our position in world markets.

Some of the defects in the current budget presentation which hamper sustained efforts to increase productivity include:

The failure of the unified budget structure to distinguish between spending for investment and spending for current consumption has inadequately framed the policy debate for decision makers, leading to significant under funding in areas critical to future economic growth and productivity.

The budget structure also has become a hindrance to sound fiscal policy making for the following additional reasons:

Overview of a Restructured Budget

It is imperative that the nation invest in its future, in the human and physical capital that will stimulate productivity and economic growth. The budget must become a tool that leads to sound decision making on federal fiscal policy.

To accomplish this goal, this document proposes that the unified budget be divided into three discrete budgets:

Each of these budgets is described in detail in Parts II-IV.

PART II. CAPITAL INVESTMENT BUDGET

The failure of the budget to make the critical distinction between capital investments and operating expenses hampers and complicates economic decision making. Neither the Chief Executive nor the Congress have had the ability to identify and set in policy the needed balance between spending for short-term consumption and spending for long-term investments which provide basic infrastructure and/or enhance productivity.

The Capital Investment Budget (CIB) proposed here would report both capital revenues and capital investments. Capital revenues would include all taxes and user fees which are earmarked by law to finance specific capital investments. Capital revenues also would include loan interest and principal repayments, as well as interest paid by the Treasury on securities held by capital trust funds.

Capital investments would include all direct capital expenditures and the subsidy cost of loans which increase investment. This is consistent with the credit reform enacted by the Congress in 1990 and is the treatment recommended by the GAO.

The guiding principals used in determining which programs and activities are capital assets which should be included in the Capital Investment Budget can be summarized in the following questions:
 

What has multiple year life?
What raises future productivity?

The answers to these questions lead to the identification of physical capital, research and development (R&D) activities (both defense and civilian), and possible options to include human capital investments, such as education and training.

Most States currently have separate capital and operating budgets. Typically, the capital budget is financed through the issuance of long-term debt instruments and through dedicated revenue sources, particularly user fees. The operating portion of State budgets, including the cost of servicing the debt of the capital budget, is the part of State budgets that is typically subject to statutory or state constitutional balanced budget requirements. An important distinction between the proposed CIB and State and local government capital budgets is that the CIB would be a vehicle to facilitate decisions on the appropriate level of public investment, while State and local capital budgets primarily reflect financing mechanisms.

Adoption of a CIB should be coupled with a presidential directive to OMB and the executive branch departments and agencies to develop meaningful rate-of-return estimates. The rate-of-return criteria would enable the Executive Branch and the Congress to make public investment decisions with a common basis for comparison between types of investments, and would provide criteria to determine whether an investment should be undertaken. Using rate-of-return as a decision criteria could well become an incentive against inclusion in the CIB of programs with mushy objectives and no way to assess effectiveness. If a CIB is adopted, there could be substantial political pressure from congressional authorizing committees and from interest groups to include their favored programs in the CIB, under the presumption that inclusion in the CIB might make a program immune from cuts and garner support for increased funding. Such a presumption would be false if the programs in the CIB are assessed in terms of rate-of-return criteria, which is used in the private sector in making investment decisions, but has seldom been applied in Federal government investment decisions.

A process could also be created to screen any additional programs that may be proposed in the future for inclusion in the Capital Investment Budget. An Advisory Committee including the Comptroller General and the director of the Congressional Budget Office could be created to advise on recommendations for inclusion of new programs in the Capital Investment Budget. For constitutional and procedural reasons, this committee should be advisory only. (1)

Adoption of a CIB also would necessitate development of depreciation schedules for physical capital. However, the treatment of depreciation in the CIB should differ from private sector practice in a fundamental way. The private sector typically integrates accrual accounting, including depreciation, into its financial management system. In contrast, the U.S. government's financial management system is on a cash basis. The reason for this is that the Congressional appropriations process exerts its control over executive branch spending at the point of obligation of funds. An executive branch official who obligates funds for which there is not a congressional appropriation is in violation of the Anti-Deficiency Act of 1905, which prescribes criminal penalties for violation, and is a codification of the longstanding Anglo-American tradition of legislative control over appropriations.

The total integration of accrual accounting, including depreciation, into executive branch financial management could weaken the control through the obligations process, and would precipitate strenuous opposition. For that reason, appropriations should continue to be on a cash basis and accrual measurements, including depreciation, should be part of the budget presentation, but not the basis for federal accounting.

For purposes of presentation and budgetary decision-making, a depreciation schedule for capital investments should be developed and applied, resulting in the net capital investment amount. It will take some time to develop rigorous estimates, but since the depreciation schedule is intended for use in fiscal decision-making, as opposed to financial management and accounting, implementation of a Capital Investment Budget need not wait on development of depreciation schedules. The amount by which net capital investments exceed capital revenues has been termed by GAO as "capital financing requirements." GAO uses this term, rather than "capital deficit" in order to reflect the fact that the government is financing a capital asset which has value and will produce a stream of benefits in the future.

At some point in the future, after depreciation schedules have been refined and tested, it may be desirable to incorporate depreciation more fully into the financial management and accounting system. The use of depreciation as a decision tool, as recommended here, clearly would be more prudent in the shorter term.

The following series of tables set forth the proposed Capital Investment Budget (CIB). These tables include Fiscal Year 1997 actual expenditures in these areas, as reported in the President's Budget for Fiscal Year 1999. These figures are drawn from the budget itself and from an OMB illustrative presentation of capital investment.

Of significance in the executive branch decision-making process is that the OMB annual estimates of capital expenditure are pulled together after the President and the OMB Director have made all the decisions on the budget. Thus, they are an ex post facto informational presentation, not part of the budgetary decision process. Nor are they built into the Congressional Budgetary decision-making process.

These estimates contain a number of program activities that are only part of an appropriations account. After adoption of a basic CIB structure, some refinement and splitting of accounts, as appropriate, could be made in consultation with the Appropriations Committees.

Physical Capital Investment - Defense Related

Table II sets forth national defense outlays for major public direct physical capital investment.

The difference between the OMB illustrative presentation of capital investment and the recommended total for the CIB presented here is that the CIB excludes defense procurement, which fails to meet the test of raising future productivity. Defense weapon systems and related equipment under the concept developed for the Capital Investment Budget can be compared to consumer durables, not to capital investment. This distinction also utilizes the criteria that federally-owned capital programs that have as their principal purpose acquisition of assets to help federal agencies achieve their missions should be excluded, unless the agency's mission is investment in nature.
 
Table II 
National Defense Outlays for Major Public Direct Physical Capital Investment: 1997 
(in billions of dollars)
 
Department of Defense-Military Atomic Energy and Other Defense
 
OMB ILLUSTRATIVE PRESENTATION
 
Fiscal Year Total Procurement Military Construction Family Housing Rehab. of Phys. Assets Major Equipment
1997...Actual 52.49 47.56 3.16 1.01 0.54 0.22
 
CIB RECOMMENDED PRESENTATION
 
1997... 

Actual

4.93 N/A 3.16 1.01 0.54 0.22
 
Source for OMB Illustrative Presentation: Budget of the United States Government Fiscal Year 1999 (January 1998), Analytical Perspectives, pp. 123-131.
 
SUMMARY: Include defense military construction, family housing, and rehabilitation of physical assets for atomic energy in the CIB, but exclude military procurement, in defense direct physical capital investment for a total of $4.9 billion in Fiscal Year 1997.

Physical Capital Investment - Civilian

Table III sets forth Civilian Outlays for Major Public Physical Capital Investment. This table includes direct federal investment as well as investment financed through grants.
 
Table III 
Composition of Non-Defense Outlays for Direct Capital Investment and 
for Grants for Major Public Physical Capital Investment: 1997 
(in billions of dollars)
Category 1997
 
DIRECT CAPITAL INVESTMENT
Water and Power Projects and Other 1/ 12.58
Acquisition of major equipment 6.89
Total: Direct Capital Investment 19.47
 
GRANTS
Transportation:
Highways... 20.50
Urban mass transportation... 4.07
Airports... 1.49
Total transportation... 26.06
 
Community and regional development:
Block grants... 4.52
Other... 1.22
Total community and regional development... 5.74
 
Natural resources and environment:
Pollution control facilities... 2.32
Other... 0.18
Total natural resources and environment... 2.50
 
Housing and other:
Housing assistance... 6.02
Other construction... 0.15
Other physical assets... 1.02
Total Housing and Other 7.19
Total: Grants 41.49
Grand Total: Direct and Grants 60.96
 
1/ Includes Corps of Engineers, Bureau of Reclamation, power marketing agencies, Nuclear, Postal Service, GSA buildings fund and Veterans hospitals.
 
Source: Budget of the United States Government, Fiscal Year 1999, Analytical Perspectives, pp. 123-131
Some comments on Table III include:

The treatment of community and regional development funding is a close call. In general, block grants probably should not be included in the CIB because by definition, it is difficult to calculate rates of return if funds are given to states with broad discretion in how they will be spent. On the other hand, there is no question that community development block grants represent an important way to encourage development of infrastructure in urban areas. For that reason, community development funding is included in the proposed CIB on the grounds that it is used primarily for infrastructure investment.

SUMMARY: Include the non-defense programs included in Table III in the CIB. Under this option, non-defense outlays for direct capital investment and for grants for major public physical capital investment total $61 billion in Fiscal Year 1997.

Research and Development (R&D) Investment

Table IV sets forth the composition of R&D Outlays for Defense and Civilian programs as proposed for inclusion in the CIB.
 
Table IV 
Composition of Outlays for the Conduct of Research and Development: 1997 
(in billions of dollars)
Category 1997
 
National defense:
Department of Defense... 37.70
Atomic energy defense... 2.48
Total national defense... 40.18
 
General science, space, and technology:
NASA... 8.14
NSF... 2.02
Atomic energy general science... 0.70
Subtotal: general science, space, and technology 11.25
Energy... 2.64
Transportation:
DOT... 0.49
NASA... 1.24
Subtotal: Transportation 1.73
Health:
NIH... 10.60
Other... 0.61
Subtotal... 11.21
Agriculture... 0.97
Natural resources and environment... 1.59
All other... 1.22
Total non-defense 30.61
Total Conduct of Research and Development... 70.78
 
There are several conceptual problems in the inclusion of research and development. The first is that basic research by its very nature cannot be subjected to rate of return analysis. Basic research is intended to increase the knowledge base, not to result in an identifiable payoff. If the payoff is identifiable, it generally would be applied research or development. However, excluding basic R&D would create a dilemma, since basic R&D is an important part of federal support for technological advancement.

The second conceptual issue is how to treat defense R&D. The GAO feels that defense applied R&D should be excluded from investment because such applied research is often not transferable to a civilian application. However, given the demonstrated historical pay-off to the economy of some past defense R&D, such as that originally undertaken for purposes of communications intelligence and atomic energy, and radar development for air defense, it would appear incongruous to exclude it, while including domestic R&D. The treatment of R&D in a capital budget is an example of the tortuous debates that can be generated about what programs are appropriate for inclusion.

In this proposal, all Federally-funded research and development would be included in the capital budget and assessed as an end-product that increases the knowledge base, not as an investment that must be followed by procurement of a product. Indeed, a decision following basic and/or applied research not to procure does not mean that the investment was a waste. It means that increased knowledge allowed policy makers to avoid making an unwise procurement of a capital good. Further, the increased knowledge may well lead to private sector innovation and investment. This rationale would support the previous option not to include defense procurement in the CIB, and to include defense R&D.

SUMMARY: Include in the capital budget funding for both defense and non-defense basic and applied research and development. Under this option, outlays for R&D in the CIB were $70.8 billion in Fiscal Year 1997.

Human Capital Investment - Education and Training

The GAO does not include education and training in its proposed capital budget. Typically, State and local governments only include in their capital budgets physical investment for education. On programmatic grounds, however, there is a basis for a distinction between federal and State and local budgetary treatment of education as an investment. Local governments finance most public education in the United States, often from dedicated revenues such as property taxes, with states providing additional support. The Federal government funds elementary and secondary education primarily for two purposes: (1) to provide seed money for innovation, and (2) to reduce funding disparities because of differing state and local tax bases as well as concentrations of disadvantaged students with greater educational needs in certain communities and states.

Clearly, the first purpose is a form of investment. The second is essentially based on the assumption that there is a national interest in providing adequate educational opportunities for all jurisdictions, regardless of their taxing ability and the number of students with special needs. This can be justified as a form of public investment enabling at-risk students to become productive members of society.

Higher Education funding, primarily grants and loans to provide access, vocational education, and employment training programs are all directly related to preparing individuals to enter or progress in the labor force. Education programs create the human capital needed for a productive work force. Table V sets forth the composition of outlays for the conduct of Education and Training which would be appropriate for inclusion in the CIB.

Table V includes funding for the conduct of education and training, not for investment in physical structure. The relatively small Federal education investment in physical structures was included in Table III. Grants and loans for elementary, secondary and post secondary education would be included in the CIB in this category, as would vocational education, training, and employment assistance programs.

The inclusion of education and training in a Capital Investment Budget has pluses and minuses. It is incorporated here to reflect the importance to future productivity of investing in an educated workforce.
 
Table V 
Composition of Outlays for the Conduct of Education and Training 
1997 
(in billions of dollars)
Category 1997
 
Direct Federal outlays:
Elementary, secondary, and vocational education... 0.81
Higher education... 12.22
Training and employment assistance... 1.00
Health (incl. Veterans). 0.88
Veterans education, training and rehabilitation... 1.48
All other... 2.63
Total Direct... 14.02
 
Grants to State and local governments
Elementary, secondary, and vocational education... 14.21
Higher education... 0.08
Research and general education aids... 0.28
Training and employment assistance... 3.77
All other... 0.51
Total Grants... 18.84
Total conduct of education and training... 37.86
 
SUMMARY: Include in the CIB funding for the conduct of education and training as described in Table V. Under this option, outlays for the conduct of education and training in the CIB were $37.9 billion in Fiscal Year 1997.

Other Human Capital Investment

Other programs and activities which promote the health and well being of individuals could be characterized as "investing" in their further productivity. Taken to its extreme, any program which provides food, health services, housing or income with which to purchase such products and services could be identified as human capital programs. While this may be a useful and legitimate construct for some purposes, it is problematic in the framework of a federal capital budget; and therefore, basic health and social programs are not recommended for inclusion in the capital budget.

Direct and Guaranteed Loans

Included in the proposed CIB are Federal direct and guaranteed loans that increase future productivity. Such credit activities should be assessed against the rate of return criteria as proposed for direct Federal spending. The cost of Federal credit in the investment budget is the cost of the subsidy. This treatment is consistent with the credit reform provisions enacted in 1990. This treatment is also consistent with GAO proposals.

Table VI shows actual Fiscal Year 1997 outlays as continued in the President's Budget for Fiscal Year 1999 for the subsidy cost of direct and guaranteed loan programs that are proposed for inclusion in the CIB. These estimates are informational only. The subsidy costs of these programs were subsumed in the earlier tables.
 
Table VI 
Subsidy Outlays for Direct and Guaranteed Loans 
Fiscal Year 1997 
(in billions of dollars)
 
Direct Loans
Rural Housing Insurance Fund 0.20
Rural Development Loan Fund 0.02
Rural Utilities Service 0.07
Small Business Administration: Disaster Loans 0.19
Federal Direct Student Loan 0.19
Total Direct Loans 0.67
Guaranteed Loans
Rural Housing Insurance Fund 0.01
Agricultural Resource Conservation Demonstration 0.00
Guaranteed Student Loans: Stafford 2.70
Guaranteed Student Loans: PLUS 0.06
Guaranteed Student Loans: Consolidated 0.05
Health Professions Graduate Student 0.00
Small Business Administration Business Loans 0.18
Total: Guaranteed Loans 3.00
Total: Direct and Guaranteed Loans 3.67
 
Some comments on programs that are excluded.

Summary of Programs and Funding Included in the Capital Investment Budget

Spending in Fiscal Year 1997 for programs proposed for the CIB totaled $174.5 billion, which was 10.9% of spending in the unified budget in 1997.
 
Table VII 
Summary of Activities Included in CIB 
Fiscal Year 1997 
(in billions of dollars)
National Defense Outlays for Direct Investment  4.93
Non-Defense Outlays for Direct Capital Investment 19.42
Non-Defense Grants for Major Public Physical Capital Investment 41.49
Subtotal: Non-defense Direct Outlays and Grants for Capital Investment 60.96
Research and Development 70.78
Human Capital-Education and Training 37.86
Totals 174.5
 

Financing of Capital Investment Budget

Table VIII shows how the CIB budget would be financed. As with the previous tables in this testimony, the numbers are Fiscal Year 1997 actual expenditures as presented in the President's Fiscal Year 1999 Budget.
 

Table VIII 
Financing of Capital Investment Budget 
Fiscal Year 1997 
(in billions of dollars)
Excise Tax and Misc. Receipts to Trust Funds
Highway 23.9
Airport and Airway 4.0
Other Excise and Misc. 0.5
Subtotal: Excise Tax and Misc. Receipts to Trust Funds 28.4
Interest Payments to Trust Funds
Highway  1.4
Airport and Airway 0.5
Other TF Interest 1/
Subtotal: Interest 1.9
Total: Interest, Excise Tax, and Misc. Receipts 30.3
Total: Outlays 174.5
Amount to be Financed or Paid by General Revenues  144.2
1/ less than 0.1
 

Implementing a Capital Investment Budget

As long as the appropriations structure is not disrupted, the President could implement the CIB in his budget request without formal congressional approval. Realistically, the Congress at least in the initial budget would treat this as a presentation issue. Over time, however, as the CIB would become institutionalized, it would become a primary mechanism of decision making, much as Stockman and Darman instituted when they successfully were able to make the budget aggregations between entitlements, defense, international relations, and domestic discretionary the basis for decisions by both the Congress and the Executive Branch.

The CIB would lead to specific considerations of appropriate levels of federal investment. Reprioritizing government spending toward investment rather than consumption would provide investment returns that would accrue to the nation as a whole. Greater productivity and more vigorous economic growth would help to reduce potential future federal deficits, and combined with other fiscal policies, would lead to continued balance in the government's operating budget. Continued focus on investments with measurable economic returns should result over time in the ability to draw down the public debt.

PART III.     INVESTMENTS IN AND FOR CURRENT, FUTURE, AND RETIRED
           &nbs p;          WORKERS

In the Executive Order creating the Commission, one of the specific areas on which the Commission was directed to report includes "distinctions among investments in and for current, future, and retired workers." While investments in current and future workers through education and training programs were discussed in the previous section and proposed for inclusion in the Capital Investment Budget, the federal government makes other investments in and for workers and retirees.

Unlike the private sector, where businesses cannot include pension assets held on behalf of individuals, either in their assets or their bottom lines, the federal government places in its annual budget the surpluses from:

This accounting practice has created great distortions in the federal budget and has masked the true nature and size of federal deficit spending. For instance, the much vaunted "surplus" expected in this fiscal year, includes counting these programs in the bottom line of the budget. If estimated surpluses in these accounts and other trust funds were segregated from the operating budget, as private sector employers do with their pension assets, the budget for Fiscal Year 1998 would go from CBO's projected surplus of $63 billion to a deficit of $86 billion.

During the 1980's, the government moved from a pay-as-you-go policy for retirement trust funds to a strategy to build up balances in the trust funds, particularly the cash benefit Social Security funds and the Federal employee retirement and disability funds. Now for the retirement benefits of about two thirds of Federal employees, the Federal government fully accrues each year their pension liability, in much the same manner as private employers fund their employee pensions.

The balances in these accounts, which are held by U.S. government trust funds, must by law be invested in U.S. government securities. At the end of 1997, these trust fund balances totaled $1.3 trillion. To the extent that trust fund balances finance deficits in Federal programs which should be paid for with general revenues, the trust fund assets are not adding to national savings and invested to finance the future obligations they represent. Ultimately, trust fund balances are IOU's on the future productive capacity of the U.S. economy. To the extent that these assets are used to finance current government consumption, these resources are not available to expand the productive capacity of the economy so that the burden will be less onerous when these trust fund IOU's need to be redeemed.

Using Retirement Funds and Unemployment Insurance to Mask Deficits Distorts the Purposes of the Programs.

These programs are used to mask total governmental expenditures in several ways. First, because revenues for these purposes are aggregated with all other revenues, and spending aggregated with other spending, the surpluses in these trust funds are netted into the budget well before the bottom line, even though they cannot by law be spent for any purpose other than the statutory purpose for which each was created. These surpluses are borrowed by the government from the trust funds, but the borrowing does not appear in the budget.

Nothing better illustrates the problems resulting from inappropriate use of Trust Fund surpluses to mask deficits than the controversy over extension of unemployment insurance benefits during the last recession. At the time that extended unemployment insurance benefits were vetoed in 1992, there was a total balance of $47.5 billion in the unemployment insurance trust funds, enough to provide extended benefits as was done in other recent recessions, to all long term unemployed workers who had exhausted their benefits and were still looking for work.

Why were these funds denied to unemployed workers for months when the funds were

paid in as taxes by employers to be used for this purpose? The answer is simple, unemployment trust funds were held hostage by the budget process. The notion that an extension of unemployment benefits in a recession must be deficit-neutral in the Federal budget turns the traditional approach to financing this system upside down. The original goal of the unemployment insurance program was to run surpluses in good times and deficits in hard times, with surpluses rebuilt in the following recovery.

The budgetary rules held the UI trust funds to a new standard, that unemployment insurance should be deficit-neutral even during periods of high unemployment, and even surpluses in the Trust Funds could not be used for their intended purpose. Over the months that Congress wrangled over extensions of benefits, the balances in these funds increased by half a billion dollars. It is unconscionable that employers paid into the insurance funds, building surpluses to pay benefits, but the surpluses were not used to finance unemployment benefits during the recession. It is easy to ignore this problem in periods with low unemployment like the present, but this problem will be back to haunt us in the next recession.

This example of undermining the Unemployment Insurance system because its surpluses are in essence locked up by the budget, hampering their use for the intended purpose, raises an ugly specter of the types of manipulation that could occur when the Social Security surpluses will need to be drawn down to finance the retirement of the baby boom.

Unified Budget Understates Operating and Interest Expense

Although the federal government must pay interest each year on all the funds it has borrowed in the past, the interest the government pays to these and other trust funds does not show up in the bottom line of the budget or in the deficit calculations. (2) Instead, interest paid to trust funds is subtracted from total interest payments before the interest amount is reported in the federal budget. This creates a perverse incentive for budget officials to propose cuts in spending for these programs. For instance, if $5 billion were cut from social security benefits, the balance in the Trust Fund would be $5 billion higher because of the benefit reduction, and the deficit would appear to be $5 billion less even though the government is actually borrowing the $5 billion, which one day will have to be repaid to the Trust Fund. Moreover, the interest that the government will owe every year on that $5 billion will also not show up in the federal budget.

Finally, when the federal government owes payments to these Trust Funds, as required by law to finance contributions as an employer on behalf of its own (federal) employers, whether for social security, unemployment insurance, or federal employee pensions, the payment is made by the employing government agency and counts as spending for that agency, but it is then subtracted from the budget in a special budget function called "Undistributed Offsetting Receipts." In this way, the unified budget hides the cost of the government providing benefits for its own employees. The payroll taxes, pension contributions, and unemployment insurance payments which a private sector firm pays for its own employees are clearly recognized as an immediate cost in the firm's accounting. The same should be true in the federal budget.

Proposed Federal Budgetary Treatment of Pension and Unemployment Insurance (UI) Funds

Table IX sets forth the programs under which funds are expended on past commitments to workers and invested to provide future benefits for workers and retirees. It includes social security and other pension benefits, unemployment insurance, and workers' compensation. These funds are proposed to be segregated in a Pension, Income Replacement Budget.
 

Table IX 
Pension, Income Replacement Budget 
1997 Outlays 
(in billions of dollars)
1997 Actual
Social Security
362
Railroad Retirement and Other General Retirement 4
Federal Civilian Employee Retirement and Disability 46
Military Retirement 30
Veterans Compensation and Benefits 19
Unemployment Compensation 21
Total 482
Most of the programs proposed for inclusion in the Pension, Income Replacement Budget are financed through trust funds in which dedicated revenue (primarily payroll taxes from employees and their employers) is earmarked to finance benefits and administrative costs. The major exception is Veterans Compensation, which is financed with general revenues and functions as a form of disability and worker compensation program for former military personnel and their survivors. Benefits in Veterans compensation are tied to injuries, wounds, or death while in military service and are not means-tested. No means-tested programs are proposed for inclusion in the Pension Budget. For that reason, Veterans pensions are not recommended for inclusion since benefits in this program are tied to current income and assets.

Medicare is not proposed for inclusion in this budgetary treatment, even though it is part of the federal government's commitment to workers. The major argument against inclusion of Medicare is that health programs, including Medicare, do not increase the incomes of individual recipients by the amount of the health benefits they receive. If that were true, a terminally-ill individual would be counted as very wealthy. Thus, from that perspective, it is neither income replacement, as a pension, or an investment in future benefits. Nor would it be wise to separate budgetary consideration of Medicare from other federal health related expenditures.

Social Security is the largest program proposed for this Pension Budget. By law, Social Security is not in the Federal budget. Congress in three separate laws over the past decade has directed that Social Security be off-budget. This law has been honored more in the breach than in the observance, however, because the Budget has continued to present all Federal spending and revenues together, not disaggregated between on- and off-budget activities. Placing Social Security in this new Budget category has the advantage of keeping Social Security out of the operating budget, consistent with Congressional intent in taking Social Security off-budget.

Accounting Treatment of Trust Funds in the Pension Budget

The accounting for statutorily required payments to these Trust Fund would be treated in the Restructured Budget as follows:

(1) Revenues to these Trust Funds would not be aggregated with other revenues. Such revenues from whatever source would be counted directly as revenue to the appropriate Trust Fund. Revenues for Fiscal Year 1997 are shown in Table X below. (Revenues earmarked by law to trust funds that are included in the Capital Investment Budget set forth in Part II of this testimony would be treated in the same manner.)

(2) Revenues to these Trust Funds which are received from the general fund would be counted as outlays from the general fund. Interest paid to these trust funds also would be included as outlays from the general fund in Function 900: Interest. This function is currently named Net Interest because interest payments to trust funds and other government entities are netted out of the total. Under this proposal to re-structure the budget, the interest function would also show all interest payments to Trust Funds in the proposed Capital Investment Budget and in the proposed Pension Budget. Pension contributions and payroll taxes would be paid from the general fund to the appropriate trust fund and would be counted as outlays in the budget of the employing agency, as is now the case, but they would not be subtracted from outlays, as they are now, in the "Undistributed Offsetting Receipts" section of the budget.

This Pension Budget would be totally separate from the Operating Budget, which hopefully would end the manipulation of programs solely for the purpose of masking the operating fund deficit. Surpluses from the programs could still be invested in Treasury securities as they are now, but the borrowing and associated interest payments would be made explicit. An issue distinct from but related to creation of the Pension Budget, is whether such funds could or should be invested outside of Treasury securities.

For instance, there have been proposals to invest in private sector stocks or bonds or in federal activities that would promote economic growth, such as infrastructure investment. Changing the investment policies for social security and UI surpluses, and/or federal employee pension assets should only be undertaken after careful study to determine that risk can be limited to acceptable levels.

Budget Estimates for the Pension Budget

Table X gives more detail on the major trust fund programs proposed for inclusion in the Pension Budget.
 
Table X 
Sources of Revenue to the Major Trust Funds 
Proposed for Inclusion in the Income Replacement Budget 
Fiscal Year 1997 
(in billions of dollars)
Social Insurance Taxes and Contributions Interest on Trust Fund Balances  Government Payment as an Employer Other Total Income to Trust Funds
Social Security (OASDI) 392 41.2 7.7 7.7 448.7
Railroad Retirement 4.1 1.2 3.9 9.3
Unemployment Compensation 28.2 3.7 0.6 32.5
Federal Employee Retirement Programs
Federal Civilian Retirement 4.4 31.2 14.2 21.6 71.4
Federal Military Retirement 0.0 11.9 11.1 15.2 38.2
Total 428.7 89.2 33.0 49.0 600.0
 
Table X shows that the income to the major trust funds proposed for inclusion in the Pension Budget was $600 billion in Fiscal Year 1997. The largest source of this revenue was dedicated taxes, which was $428.7 billion. Payments by the Federal government as an employer, such as the employer share of FICA which finances Social Security, added $33 billion in revenue.

The largest item in the "other" category is $21.6 billion for Federal employee retirement. This includes interest payments on the portion of the unfunded liability that is attributable in part to the Federal government's past failure to fully fund the system. It also includes amortization payments for any liberalizations in benefits, including regular cost-of-living payments. Next are payments by the Department of Defense for the normal cost of military retirement. All of these payments are currently netted out in the bottom line of the budget. Under this budget restructuring proposal, these payments would all count as outlays in the bottom line of the operating budget. The operating budget (and the authorizing legislation) would be the arena in which the President and the Congress could debate the appropriate size of these payments.

Interest earned on these trust fund balances was $89.2 billion during Fiscal Year 1997. This interest would be paid (outlayed) from the operating budget and would be received as revenue to the Pension Budget. Table XI shows the change in the balances during Fiscal Year 1997 of the major trust funds proposed for inclusion in the Pension Budget.
 
Table XI 
Trust Fund Balances 
Fiscal Year 1997 
(in billions of dollars)
Balance Start of Fiscal Year 1997 Total Income to Trust Funds Total Outlays from Trust Funds Balance End of Fiscal Year 1997
Social Security (OASDI) 549.6 448.7 367.3 630.9
Railroad Retirement 14.1 9.3 8.3 15.0
Unemployment Compensation 54.0 32.5 24.4 62.1
Federal Employee Retirement Programs
Federal Civilian Retirement 401.7 71.4 42.2 430.9
Federal Military Retirement 131.2 38.2 30.2 139.2
Total 1150.6 600.1 472.4 1278.1
 
The establishment of a separate Pension Budget will allow the financing of these programs to be identified, and surpluses will be clearly shown in the Pension Budget. Under the current budget practices, the extent to which Trust Fund programs are self-financed is hidden, and the interest earned by these trust funds on mandatory investments in government securities is not included in the budget totals. Under the restructured budget, the true interest obligation of the Federal government would be shown in the operating budget, the government's pensions obligations would be specifically identifiable as a cost of doing business, and the extent to which the Pension and UI trust funds are self-financed would be clearly shown.

PART IV. SUMMARY BUDGET PRESENTATION

All programs not specifically identified for inclusion in the Capital Investment Budget or the Pension Budget would remain in the operating budget. Once the CIB and Pension Budgets are segregated from the general operating budget, policy makers can then easily distinguish between revenues that are for specific investments and revenues that are intended to fund the general operations of government. Interest owed would be made readily apparent. Most importantly, policy makers would be able to distinguish investment from consumption through creation of a Capital Investment Budget that specifically identifies governmental expenditures that have the potential to increase productivity and bring about greater economic growth.

Policy makers also would be able to readily identify the revenues in programs that are specifically intended to build surpluses to be invested to pay future benefits to workers and retirees. Funds collected explicitly for investment for workers would be segregated from other revenues and expenditures, just as the private sector must account for pension funds. The decisions to collect these surpluses were made with the intention of increasing net national savings, a policy which has been thwarted by use of the surpluses for current consumption in government operations. Increased national savings and the expected expanded economic growth would result in a nation better able to meet its future obligations when it comes time to draw down the social security surpluses.

Taking the necessary steps recommended here to restructure the federal budget, by instituting a Capital Investment Budget and by segregating Pension and other Income Replacement assets, will give the President and the Congress the information needed to make decisions that will benefit U.S. economic growth over the long term. Table XII provides a comparison for Fiscal Year 1997 of the budget structure proposed in this testimony to the unified budget presentation.

The deficit calculation in the Unified Budget represents the amount the Treasury must borrow each year from the public. It does not include the amount that is borrowed internally by the Treasury from trust funds, such as federal employee pension and social security, etc. Showing the surplus or deficit in each budget will better enable policy makers to understand total government borrowing and the interrelationships between expenditures and investments. To calculate the amount which must be borrowed from the public when operating under the three budgets, the surpluses and deficits from each of the three budgets can be totaled and will equal the deficit amount calculated under the unified budget. Thus the main purpose of the unified budget--the ability to assess Treasury's requirements to borrow from the public--would be retained, but better review of spending and investment priorities would be assured.

Calculating from the Total Outlays line in the following table, the outlays for the three proposed budgets combined, shows a total of $1.77 trillion, which is greater than the outlay total for the unified budget. This amount reflects total outlays, including such items as interest paid on trust fund investments and social security and pension contributions for federal employees, eliminating most expenditures hidden by the unified budget structure.
 
Table XII 
Illustrative Breakdown of Budget Actuals for Fiscal Year 1997 
Based on the Budget Restructuring Proposal 
(in billions of dollars)
Current Unified Budget Capital Investment Budget Pension Budget Operating Budget
RECEIPTS/REVENUES
Income, Estate, Gift, Customs Duties 957.5 0.0 0.0 957.51
Social Insurance, Taxes, and Contributions 539.4 0.0 539.4 0.0
Excise Taxes and Miscellaneous Receipts 82.4 28.4 0.0 54.4
Interest on Trust Fund Investments N/A* 1.9 89.2 0.0
Contributions as Employer to Income Replacement Budget N/A* 0.0 49.0 0.0
Governmental Contributions as Employer to Income Replacement Budget N/A* 0.0 33.0 0.0
TOTAL RECEIPTS 1579.3 30.3 710.6 1011.9
TOTAL OUTLAYS 1601.2
ALLOCATION OF CURRENT OUTLAYS 1601.2 174.5 482.0 944.7
ADDITIONS TO OUTLAYS IN CURRENT PRESENTATION
Interest on Trust Fund Investments 91.1
General Fund Contributions to Income Replacement Budget 49.0
Government Contributions as Employer to Income Replacement Budget 33.0
TOTAL OUTLAYS 1601.2 174.5 482.0 1117.8
DEFICIT (-) SURPLUS (+) -21.9 -144.22 228.6 -105.9
Note: *Indicates funding that is currently netted out in the unified budget totals.
1 Assumes all non-trust fund revenues are in the Operating Budget. Policy-makers could designate some portion or specific revenues to the Capital Budget.
2 Amount to be paid by general revenues or financed. 
 
Footnotes:
1 The Constitutional issue is that the preparation of the President's budget is the responsibility of the Executive Branch, and these officials are part of the Legislative Branch. The President cannot delegate executive responsibilities to the Congress.

2 In Fiscal Year 1997, net interest owed on the public debt reported in the budget was $244 billion. Total interest owed, including interest to trust funds was $351 billion.


President's Commission to Study Capital Budgeting