June 1991

Playing by the Rules

V. V. Chari
Research Officer and
Preston J. Miller
Vice President and Deputy Director of Research

A synopsis of the Minneapolis Fed's 1990 Annual Report.

The federal budget mess just won't go away. Despite the discipline of Gramm-Rudman-Hollings (GRH), the government is running ever larger budget deficits, making poor decisions, and spending an inordinate amount of time on the process. In 1990 the budget deficit reached $220 billion. This year, after the torturous passage of a package of expenditure cuts and tax increases, it's projected to exceed $300 billion. Yet the original GRH deficit target for fiscal 1991 was zero. Voters are concerned; Congress is concerned; the administration is concerned. Although there is widespread agreement that something is seriously wrong with the budget process, there is less agreement about what should be done about it. In response to this concern, many proposals for reform have been suggested. Yet they miss the mark: they fail to address the problems inherent in the budget process and are not based on sound economic principles.

We provide a conceptual framework for budget policy based on economic principles. Using this framework, we propose that the federal government change accounting practices, institute rules on debt issue and impose enforcement mechanisms. Our proposal will produce budgets that are balanced over time in an appropriate rather than an arbitrary sense. Our proposal also will help inform the decision makers and the public about their policy options and the financial consequences of those options. Of course, our proposal will not cure all the ills in the budget process. Hard choices will still have to be made.

But first a bit of history. Since the late 1960s, the federal government has consistently run large deficits. These large deficits have led to a dramatic increase in the federal debt as a percentage of GNP in the 1980s. Interest payments to service this debt have absorbed an increasing proportion of our national product.

The debilitating consequences of a growing federal debt are well- known. Large interest payments leave us with less to pay for education, highways, national defense and a variety of useful causes. A growing federal debt tends to raise interest rates and to increase pressure on the Federal Reserve System to follow inflationary policies. This litany of ills may be familiar; nonetheless, it is alarming.

To make things worse, even though total non-defense expenditures have been allowed to grow at double-digit rates, too little money has been allocated for capital projects, such as highways, airports and sewer systems. Federal capital spending in fiscal 1991 is projected to be roughly 2.2 percent of GNP, down from 4.4 percent of GNP in the early 1960s. Construction expenditures, which are an important component of capital spending, have declined over the postwar period. Surely we can do better than to leave our children decayed highways, crumbled bridges and antiquated sewer systems, with little or no ability to repair or replace any of them because of the enormous tax bills coming due for services consumed before they were even born.

We are not the first to offer solutions: The Gramm-Rudman-Hollings Act (GRH) and the reforms of last fall were attempts to respond to these problems. While these attempts to reach a balanced budget are laudable, we think our proposal is better. Specifically, we propose that the federal government adopt the following:

• Record transactions on an accrual basis and maintain separate operating and capital budgets,
• Require that the combined operating budget in the current fiscal year and subsequent fiscal year be balanced, and establish overall limits on capital spending,
• Institute enforcement mechanisms based on performance to ensure that the rules are being followed,
• Set up rainy day funds to meet contingencies.

We would, of course, not be averse to an escape clause suspending the rules in the event of a war or national emergency. But we think that such suspension should require a supermajority of votes in Congress and the assent of the president.

Why do we need these or any rules at all? Why not rely on policymakers to make good decisions? The problem is that the policymaking process is fundamentally biased against the future. While voters care about the future, a lack of information about politicians' actions causes voters to judge performance based on recent results. Knowing this, politicians skew their actions in a way that provides good immediate results but shortchanges the future.

This policymaking bias against the future is not unique to the government. Corporate stockholders face many of the same problems as voters in deciding whether corporate managers are acting wisely, and how those stockholders address those problems suggests solutions for voters. For example, adoption of standard accounting practices for accurate presentation of information, corporate charters to limit management indiscretion and incentive contracts for managers have proved effective for the private sector.

In short, without rules to constrain policy decisions, we will continue to have bad outcomes. So the question is not whether to have rules, it is which rules to have. The current rules do not address the bias, nor are they based on sound economic principles.

The Case for our Rules: Basic Principles

Our budget proposal is a set of reforms intended to reduce both the policymaking bias and the confusion associated with current procedures, and it's guided by four basic economic principles.

First, the budget should be balanced in a present-value sense without use of the inflation tax. This principle is based on an accounting identity and on a stated goal of macroeconomic policy. The identity says that what goes out from the government must come in, and it implies that the present value of government expenditures cannot exceed the present value of government receipts. These receipts can include proceeds from the inflation tax; however, with zero inflation as the stated goal of monetary policy, the first principle follows.

Second, benefits should outweigh costs. This follows from the theory of economic policymaking which requires that government officials weigh alternative programs in terms of their economic benefits and costs to society. Since the services of programs occur over time, the government must measure benefits and costs in expected, present-value terms. Those benefits and costs are dated to occur when resources are transferred in and out of the private sector. Thus, when the government hires workers, the economic cost occurs when the workers enter the public sector and not when the government gets around to mailing their checks.

The third economic principle is that users pay. That beneficiaries of government programs should pay is partly a fairness argument. It also has the virtue of making it more likely that the benefits of public programs exceed their costs, since those costs cannot be pushed off on non- involved parties. This principle suggests that borrowing to finance current consumption is unacceptable because that method of financing pushes the costs off to future generations who do not benefit from the consumption. In contrast, it also suggests that borrowing to finance capital spending is acceptable since future generations will benefit from the services of that capital.

Our fourth economic principle, tax smoothing, is an implication of studies of the tax structure, which find that it is costly to make frequent, sharp changes to tax rates. Tax smoothing means that when the government has commitments to spend in the future, it should begin taxing for them today. What this means in practice is that it's more efficient to raise taxes a little bit now and keep them there than it is to wait and raise them a lot when the spending takes place.

We believe that these four simple principles suggest reforms of the budget process which help deal with the policy bias problem. We also believe they can provide guidance on many current budgetary issues.

Our Reforms in More Detail

Our proposal for reform is hardly radical. It is composed of modest changes in accounting procedures, rules on debt issue and enforcement mechanisms. Most of the changes are either incorporated into budget practices of corporations and state and local governments or included in other proposals for federal budget reform.

The accounting changes we propose are that expenditures and receipts be recorded on an accrual basis and that separate accounts be maintained for operating and capital items. These accounting changes follow directly from our cost-benefit timing and user-pays principles. Our cost-benefit timing principle requires that expenditures and receipts be recorded when the activity giving rise to them occurs; that is, they should be recorded on an accrual basis. Our user-pays principle suggests that it is not appropriate to borrow for operating expenses but it may be appropriate to borrow for capital. Therefore, it follows that separate accounts should be maintained for operating and capital items.

The rule changes we propose limit the amount of debt the government can issue on its operating and capital accounts. The rules follow from our principles and from our attempts to reduce the policy bias. Although they involve only minor changes to existing rules, they provide explicit policy targets.

We propose to limit the debt that can be issued on the operating budget by requiring that the combined estimated and projected budget balance be zero in the current and subsequent fiscal year. The proposal allows operating debt to be issued temporarily when there is a mistiming of payments and receipts, or when unforeseen spending increases or revenue losses occur.

We propose to limit the debt that can be issued on the capital budget by requiring Congress to pass a bill annually authorizing debt issue up to a specified ceiling. While this is much like current procedures, our ceiling applies only to debt issued to finance capital spending. This means that the ceiling would be an independent control on capital spending.

We propose to enforce the rules using approaches similar to current practices. The rule on operating debt would be enforced with a sequester; the rule on capital debt would be self-enforcing. The Treasury simply would not be authorized to issue debt above the legislated ceilings.

Our proposed reforms so far are derived from our economic principles of present-value balance, cost-benefit comparison and user-pays, but seem in conflict with our tax-smoothing principle. The reason is that government spending and revenues fluctuate due to causes that cannot be perfectly anticipated. Wars and recessions are as likely to occur in the future as they have in the past, but it's hard to know when. Therefore, meeting the two-year balanced budget rule would require sharp changes in tax rates when these contingencies occur. To avoid these kinds of changes in tax rates, we propose that rainy day funds be set up to meet contingencies. These rainy day funds would be set apart from the operating budget.

What Our Reforms Will Accomplish

Our reforms are intended to lessen the government's bias to overly discount the future and to remove some of the confusion that surrounds current budgetary practices. We argue that they lessen the bias by making deficit financing more difficult, capital spending more attractive and procrastinating more costly. We argue that they reduce the confusion by providing a framework based on economic principles.

Our proposal discourages deficit spending through a number of technical changes. However, the most important contribution the proposal makes to controlling deficits is that it provides a definition of budget deficit and specifications of targets that are guided by economic principles and, thus, have some logical basis.

As for capital spending, our method puts capital spending on a more equal footing with current spending. If the government decided not to purchase capital equipment, our method would show that the savings in current expenses would be only depreciation and interest. According to current practices the savings would be the cost of the capital purchase, which is much larger. As a result, current practices make cuts in capital spending look more attractive to policymakers than they really are.

To discourage procrastination, we would require that, when possible, the government's assets be carried on its books at the lesser of cost or market value. If the government did not maintain such assets appropriately, their market value would fall, resulting in a larger depreciation charge and adversely affecting the government's operating budget. When the assets do not have an apparent market value, such as a nuclear armaments plant, they would be carried at cost. However, if they were not properly maintained, they would cease being useful prematurely, and the government then would be forced to write off the asset as depreciation on the operating budget.

Our method also requires quick action to balance the budget when circumstances change. In this sense, under our proposal the federal government would be forced to act like state and local governments now do. Under our proposal, difficult choices could not be simply passed on to future Congresses and administrations.

Transition

How do we get from the current system to our proposed system? Some of our reforms—accrual accounting and separating the capital and operating budgets—could and should be adopted for fiscal 1992. All that is required is that policymakers look at a different set of books. However, an immediate move to a balanced budget would require enormous and disruptive increases in taxes, or reductions in spending. We believe the government should move to a balanced operating budget over a three-to-five-year period. Over this period, the goal of monetary policy should be to reduce the inflation rate gradually to zero.

Our Rules Are No Panacea

We would like to conclude by claiming it would be all smooth sailing if only our proposal were accepted. But of course we know that's not true. No change in the process can make the difficult choices confronting policymakers easy. They still would have to decide whose ox to gore by cutting spending or increasing taxes. But we think policymakers would make better decisions if they understood what they were up against and what the consequences of their actions would be. No change in budget process is going to solve the policy bias problem or keep the government out of financial difficulty. Better budget processes than the federal government now employs have not stopped these problems with corporations or state governments. We nevertheless strongly believe our proposal can lessen the magnitude of the problems.

The budget mess will not be completely cleaned up even if all our reforms are adopted. Hard choices will still have to be made. But we will no longer have the choice of inflicting costs upon future generations for programs that benefit us.

Top