A synopsis of the Minneapolis Fed's 1990
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
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
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
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
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.
How do we get from the current system to our proposed system? Some
of our reformsaccrual accounting and separating the capital
and operating budgetscould 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.