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Reischauer, The Brookings Institution

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Statement of Robert D. Reischauer(1)
The Brookings Institution
The President's Commission to Study Capital Budgeting
April 24, 1998
        Ms. Brown, Mr. Corzine, and Members of the Commission, I appreciate this opportunity to appear before you as you continue your investigation of the issues surrounding capital budgeting in the context of the federal budget. My remarks will be brief and they will repeat some of the themes that others who have appeared before you have raised.

I have organized what I have to say around three questions:

  • First, is there conceptual justification for thinking that federal activities that produce a stream of benefits over many years should be treated differently in the budget process from those that generate all of their benefits immediately?

  • Second, is there any persuasive evidence that the nation has suffered significantly because it has not made such a distinction in the past?

  • Third, are there practical ways--that is, ways that would not cause more harm than good--of designing mechanisms to overcome whatever problems might have been created by the current set of budget rules?
        So you are not kept in suspense any longer than necessary, let me tell you that my answers to these three questions are yes, no, and no. These answers lead me to recommend that we largely retain our current practices.

I.      With respect to the first question, the federal government engages in many activities that produce immediate benefits--the so-called consumption-oriented programs. This group encompasses activities as diverse as transfer payments like food stamps, Coast Guard safety and navigational aids, National Park ranger services, and grants to the arts and humanities. But much of what the federal government spends money on in any single year produces a stream of benefits over a number of years and for that reason might be viewed as investment-oriented activities.

        Discussions about government investment have centered around long-lived capital projects or infrastructure--that is, physical investment projects such as roads, bridges, buildings, airports, and weapon systems. But it is probably the case that most of the government's activities that provide benefits over a multi-year period are softer, including such things as child nutrition programs, NIH and NSF research funding, aid to education, and Superfund clean-ups.

        Whatever their nature, there exists a real possibility that the budget decision-making process will be systematically biased against investment activities if the full cost of those activities must be recognized when expenditures are made or obligations are entered into but the benefits or services flow in over a period of years after the initial outlays are made. The reason we should expect such myopia is that we have a democratic system where politicians must stand for election every two years and are, therefore, most interested in programs that can provide immediate benefits to their constituents. Interest groups and lobbyists also fight harder and are rewarded most for projects that have an immediate impact.

        The bias against investment activities might be expected to be particularly serious in a constrained budget environment such as the one that has characterized the better part of the last three decades. It also should be acute when the built-in or current policy spending growth of the government's consumption programs is more rapid than the growth of current policy revenues, as has been the case. A competitive political environment--that is, one in which neither party seems to have a long-term lock on control of the government, and where few members feel they have safe seats--should also advantage consumption programs over investment programs.

        Mechanisms could be designed to try to level the playing field, to correct myopic decision-making in an effort to promote the broad public good. A separate capital budget is one of the alternatives that might address the possible bias against a subset of the government's investment activities--namely physical capital programs.

        But before the budget rules are modified in this direction, one would want to weigh the inevitable tradeoffs. While in some abstract sense, decisions might be better, fiscal control--another purpose of the budget--might be degraded. Similarly, the budget's macro-economic impact might be weakened by such changes. In addition, to the extent that the new rules led to an increase in the level of total government spending that was unmatched by increased revenues, it would produce a commensurate decline in net private sector investment and probably economic growth.

        The issue, then, becomes one of determining whether the benefits of a new procedure for handling investment activities in the budget would outweigh the costs of changing the current system.

II.     This brings us to the second question, which involves a judgement concerning whether the current decision making process has imposed large costs--that is, has it systematically and significantly reduced the level of resources that the nation has devoted to public sector investment activities? There is, of course, no way to answer this question. To do so, one would have to compare, at the margin, the societal benefit produced by the last billion dollars spent on government consumption activities, government investment activities, private consumption activities, and private investment activities. This is impossible to do because we have no agreed upon metric to measure societal benefits.

        Lacking this, analysts have often turned to economic measures. They have asked whether, at the margin, public sector investment activities have high benefit-to-cost ratios or rates of return that exceed federal borrowing costs or the rates of return on private sector investment. While I do not claim to have reviewed this literature extensively, the consensus view is that, at the margin, the return on public sector investment is no higher than that in the private sector. This is not to say that one cannot find some selective public sector investment activities that have very high rates of return--just as one can find some private sector projects with spectacular prospects.

        There is a straightforward reason why one would expect public sector investment, in general, to have a lower, rather than a higher, rate of return than investment in the private sector. That reason is that investment allocation decisions in the public sector involve many considerations other than the expected rate of return, which is the dominant consideration for private sector decision-making. One of these considerations is inter-area equity. On the basis of economic considerations alone, the federal government would allocate far less to roads and bridges and public buildings in North Dakota than it now does. But there is agreement that all areas of the country should enjoy the advantages of a modern highway system even where the economic payoff is minimal. For the same reason we skew projects to areas with chronically depressed local economies, reflecting the judgement that such areas should get a boost even if the public investment makes little sense from a business standpoint. Another consideration is politics. Physical infrastructure projects are often chosen more on the basis of political power than any potential economic returns they might have. West Virginia and Alaska stand out as beneficiaries of this general practice.

        In addition, some past infrastructure spending has been allocated to achieve macro-economic stabilization objectives. Aggregate spending has been increased when the economy was in recession and particular local projects have been chosen, in part, because the unemployment rate in the area was high relative to rates elsewhere.

        It is also likely that many investment projects with high benefits or returns would be undertaken with or without federal participation. This is because states, localities, individuals, and private businesses all engage in investment activities that are similar to many of those pursued by the federal government. When the federal government increases its level of activity, it undoubtedly displaces, or substitutes for, investments that would have been made by others. As a result of federal participation, the state decides not to spend its own money for a highway project, the parents no longer need to save as much for their daughter's college tuition, the pharmaceutical company no longer needs to devote as much of its budget to basic biochemical research, or the school district no longer has to issue a bond to build a new school.

        On balance, I believe that the current budget rules have not led to a serious under-allocation of resources to federal government investment-type activities--particularly physical investments. Because they are geographically specific--that is, they come with a Congressional District and state identifier attached to them--physical infrastructure projects may be viewed by many politicians as more desirable than many types of federal consumption spending, the benefits of which are hard to pin down by geographic area. Furthermore, many of our national legislators come out of state and local governments where they spent much of their time dealing with infrastructure issues and so they arrive in Washington with a bias in favor of such spending. To summarize, I do not think there is any compelling evidence to support the view that the federal budget system has biased spending away from investment activities.

III.    Of course, this judgement could be wrong and so let me turn to the third question which is whether there is a way to change the current budget rules without causing more problems than are solved. The front runner here, of course, is the proposal that the nation create a separate capital budget that would be financed through borrowing while depreciation of the assets or amortization would be included in the operating budget. You have heard the concerns about this approach from many other mainstream federal budget experts and so I will list, but not elaborate upon, them.

        First, if it were easier to expand spending on activities that were designated as "investments," there would be tremendous pressure to dress up every favored program in investment garb. Politicians, not accountants or neutral budgeteers, would, as they should, make the determination as to what was and was not an "investment." For those who doubt that this will happen, I recommend that you look at the wide range of programs that have been designated as "emergencies" under the current Budget Enforcement Act rules, the way programs have migrated from the discretionary category to the mandatory category and back again, and the imaginative use of tax policy in recent years to pursue federal objectives that would have been better achieved through spending programs. It is the last of these that worries me the most. I fear that we will turn to inefficient infrastructure mechanisms to achieve federal policy objectives because those mechanisms would not have to surmount as high a budgetary hurdle as would more effective tax or consumption-spending programs.

        Second, much of the physical investment activity of the federal government outside of the defense area produces assets that are not owned by the federal government. Roads, airports, mass transit systems, and scientific equipment are under the control of states, localities, universities, and the like. It would not make sense to have the federal government's capital accounts filled with assets that the federal government did not own.

        Third, estimates of depreciation might be difficult to develop, particularly in areas with rapid technological change. There would be a reluctance in the defense area to write off a weapons system that became worthless because of an advance by a hostile power. We would have a problem admitting the truth when a system turned out to be far less effective than was anticipated when it was tested. To provide an example, I wonder what we would have done with the B-1 bomber, which does not seem to be able to perform, with any great reliability, the missions for which it was built. What would we do with the multi-billion dollar failures to upgrade the computer systems of Medicare, the IRS, and the air traffic control system? If depreciation was included in the operating accounts of the budget, I would expect there to be considerable political pressure to manipulate those numbers within both the Executive branch and Congress.

        To conclude, I do not think the nation has paid any significant price for maintaining a set of budget rules that seems to be biased against investment activities. Furthermore, the solutions to this alleged problem, I believe, would do more harm than good.

Thank you.

1.  This statement reflects the views of Robert D. Reischauer and should not be attributed to the staff, trustees, or funders of the Brookings Institution

President's Commission to Study Capital Budgeting

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