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ANALYTICAL PERSPECTIVES BUDGET OF THE UNITED STATES GOVERNMENT Fiscal Year THE BUDGET DOCUMENTS Budget of the United States Government, Fiscal Year 2000 contains the Budget Message of the President and information on the President’s 2000 budget proposals. In addition, the Budget includes the Nation’s second comprehensive Government-wide Performance Plan. Analytical Perspectives, Budget of the United States Government, Fiscal Year 2000 contains analyses that are designed to highlight specified subject areas or provide other significant presentations of budget data that place the budget in perspective. The Analytical Perspectives volume includes economic and accounting analyses; information on Federal receipts and collections; analyses of Federal spending; detailed information on Federal borrowing and debt; the Budget Enforcement Act preview report; current services estimates; and other technical presentations. It also includes information on the budget system and concepts and a listing of the Federal programs by agency and account. Historical Tables, Budget of the United States Government, Fiscal Year 2000 provides data on budget receipts, outlays, surpluses or deficits, Federal debt, and Federal employment covering an extended time period—in most cases beginning in fiscal year 1940 or earlier and ending in fiscal year 2004. These are much longer time periods than those covered by similar tables in other budget documents. As much as possible, the data in this volume and all other historical data in the budget documents have been made consistent with the concepts and presentation used in the 2000 Budget, so the data series are comparable over time. Budget of the United States Government, Fiscal Year 2000— Appendix contains detailed information on the various appropriations and funds that constitute the budget and is designed primarily for the use of the Appropriations Committee. The Appendix contains more detailed financial information on individual programs and appropriation accounts than any of the other budget documents. It includes for each agency: the proposed text of appropriations language, budget schedules for each account, new legislative proposals, explanations of the work to be performed and the funds needed, and proposed general provisions applicable to the appropriations of entire agencies or group of agencies. Information is also provided on certain activities whose outlays are not part of the budget totals. A Citizen’s Guide to the Federal Budget, Budget of the United States Government, Fiscal Year 2000 provides general information about the budget and the budget process for the general public. Budget System and Concepts, Fiscal Year 2000 contains an explanation of the system and concepts used to formulate the President’s budget proposals. Budget Information for States, Fiscal Year 2000 is an Office of Management and Budget (OMB) publication that provides proposed State-by-State obligations for the major Federal formula grant programs to State and local governments. The allocations are based on the proposals in the President’s budget. The report is released after the budget and can be obtained from the Publications Office of the Executive Office of the President, 725 17th Street NW, Washington, DC 20503; (202) 395–7332. AUTOMATED SOURCES OF BUDGET INFORMATION The information contained in these documents is available in electronic format from the following sources: CD-ROM. The CD-ROM contains all of the budget documents and software to support reading, printing, and searching the documents. The CD-ROM also has many of the tables in the budget in spreadsheet format. Internet. All budget documents, including documents that are released at a future date, will be available for downloading in several formats from the Internet. To access documents through the World Wide Web, use the following address: http://www.gpo.gov/usbudget For more information on access to the budget documents, call (202) 512–1530 in the D.C. area or toll-free (888) 293–6498. GENERAL NOTES 1. 2. All years referred to are fiscal years, unless otherwise noted. Detail in this document may not add to the totals due to rounding. U.S. GOVERNMENT PRINTING OFFICE WASHINGTON 1999 For sale by the U.S. Government Printing Office Superintendent of Documents, Mail Stop: SSOP, Washington, D.C. 20402–9328 1 TABLE OF CONTENTS Page Economic and Accounting Analyses 1. Economic Assumptions ........................................................................................ 1 2. Stewardship: Toward a Federal Balance Sheet ................................................. 17 Federal Receipts and Collections 3. Federal Receipts ................................................................................................... 47 4. User Fees and Other Collections ........................................................................ 93 5. Tax Expenditures ................................................................................................. 105 Special Analyses and Presentations 6. Federal Investment Spending and Capital Budgeting ...................................... 139 7. Research and Development Expenditures .......................................................... 179 8. Underwriting Federal Credit and Insurance ..................................................... 181 9. Aid to State and Local Governments .................................................................. 233 10. Federal Employment and Compensation ........................................................... 247 11. Strengthening Federal Statistics ........................................................................ 253 Federal Borrowing and Debt 12. Federal Borrowing and Debt ............................................................................... 259 Budget Enforcement Act Preview Report 13. Preview Report ..................................................................................................... 275 Current Services Estimates 14. Current Services Estimates ................................................................................. 289 Other Technical Presentations 15. Trust Funds and Federal Funds ......................................................................... 335 16. National Income and Product Accounts ............................................................. 351 17. Comparison of Actual to Estimated Totals for 1998 ......................................... 357 18. Relationship of Budget Authority to Outlays .................................................... 363 19. Off-Budget Federal Entities and Non-Budgetary Activities ............................. 365 Unnecessary or Wasteful Reports to Congress 20. Unnecessary or Wasteful Reports to Congress .................................................. 371 i Page Federal Drug Control Funding 21. Federal Drug Control Funding ............................................................................ 375 Information Technology Investments 22. Program Performance Benefits from Major Information Technology Investments ................................................................................................................. 379 Budget System and Concepts and Glossary 23. Budget System and Concepts and Glossary ....................................................... 393 Outlays to the Public 24. Outlays to the Public ........................................................................................... 413 Federal Programs by Agency and Account ii 25. Federal Programs by Agency and Account ......................................................... 417 List of Charts and Tables .................................................................................................... 611 ECONOMIC AND ACCOUNTING ANALYSES 1 1. ECONOMIC ASSUMPTIONS Introduction The economy begins this year in excellent condition. Budget surpluses have replaced soaring deficits; fiscal policy is now augmenting national saving, investment and growth, rather than restraining them. Monetary policy has successfully pursued the goals of supporting economic growth while at the same time wringing out inflation. These sound policies have contributed to another year of outstanding economic achievement. Data for the first three quarters of 1998 and partial data for the fourth indicate that real Gross Domestic Product (GDP) rose about 4 percent over the four quarters of 1998, almost one percentage point faster than the average pace set during the prior five years. The Nation’s payrolls increased by 2.9 million jobs during 1998, bringing the total number of new jobs created since this Administration took office to 17.7 million—93 percent of which were in the private sector. Healthy job growth pulled the unemployment rate down further last year. By December, the rate was 4.3 percent, the lowest level in nearly three decades and 3.0 percentage points lower than in January 1993. The unemployment rate averaged 4.5 percent last year, the lowest it has been since 1969. Despite robust growth and low unemployment, inflation remained low. The Consumer Price Index (CPI) rose just 1.6 percent last year, aided by a sharp fall in energy prices. Even excluding the volatile food and energy components, the CPI rose only 2.4 percent. The GDP chain-weighted price index, the broadest measure of prices paid by consumers, business, and government, rose by around 1 percent. Not since the early 1960s has inflation been this low. The combination of a low unemployment rate and a low inflation rate pulled the ‘‘Misery Index’’—the sum of the two rates—to its lowest level since the 1960s. Both households and businesses have prospered in this environment of strong growth and low inflation. For the second year in a row, hourly earnings after adjustment for inflation increased faster than at any time in the past two decades, while the share of profits in GDP reached 10 percent during the last three years, the highest it has been since 1968. Effective policy actions and the fundamental health of the American economy have enabled it to weather an extraordinary buffeting from economic turmoil abroad. Imports, adjusted for inflation, rose last year, while exports shrank; but robust growth of domestic demand by consumers and businesses more than offset this source of restraint. The sound fiscal policies of this Administration, which produced the first Federal budget surplus since 1969, lowered interest rates and reduced the government’s demands in credit markets, thereby providing needed resources for private-sector spending. During the summer and fall, financial crises in foreign lands sent tremors through stock and bond markets. Beginning in September, the Federal Reserve responded by cutting the Federal funds rate in three successive steps, actions that restored confidence to financial markets. As 1999 began, financial and nonfinancial market indicators were signaling that the economic outlook remains healthy. The economy has outperformed the consensus forecast during the past six years, and the Administration believes that it can continue to do so if sound fiscal policies are maintained. However, for purposes of budget planning, it is prudent to rely on mainstream projections. The Administration assumes that the economy will continue to expand, while unemployment, inflation and interest rates will remain low. Real growth in the next few years is expected to moderate to 2.0 percent per year, followed by somewhat faster, but sustainable, growth thereafter averaging 2.4 percent per year. Even with more moderate growth than recently, the economy will generate millions of new jobs. The unemployment rate, which by mainstream estimates is below the level consistent with stable inflation, is projected to edge up slightly until mid-2001. Thereafter, it is projected to average a relatively low 5.3 percent, the middle of the range that the Administration estimates is consistent with stable inflation. Inflation is expected to rise slightly as the restraining influence of temporary factors wanes, but then to average just above 2 percent per year. Short-term interest rates are expected to remain in the neighborhood of levels reached at the end of 1998. Long-term rates are projected to move up by about 0.6 percentage point, the same amount as the rise in inflation, leaving inflation-adjusted long-term rates not much different than in December. Most private sector forecasts have a similarly favorable view of the outlook. The most recent Blue Chip consensus, an average of 50 private forecasts, calls for real growth of 2.1 percent this year, and 2.4 percent, on average, through 2004. Unemployment and inflation projections are also close to the Administration’s economic assumptions, while interest rates are projected to be slightly higher in the outyears of the budget horizon. The similarity with private-sector projections indicates that the Administration’s assumptions provide a reasonable, prudent basis for projecting the budget. In December, this business cycle expansion (which began in April 1991) set the record for the longest period of continuous growth during peacetime—surpassing the expansion of the 1980s. Last month marked the 94th consecutive month of growth. If the expansion continues through February 2000, it will exceed the 3 4 ANALYTICAL PERSPECTIVES longevity record of 106 months set during the Vietnam War expansion of the 1960s. The Administration expects, as do most private sector forecasters, that this expansion will surpass that record. This chapter begins with a review of recent developments, and then discusses two statistical issues: the growing statistical discrepancy (the difference between the aggregate measures of output and income); and recent methodological improvements in the calculation of the Consumer Price Index. The chapter then presents the Administration’s economic projections, followed by a comparison with the Congressional Budget Office’s projections. The following sections present the impact of changes in economic assumptions since last year on the projected budget surplus, and the cyclical and structural components of the surplus. The chapter concludes with estimates of the sensitivity of the budget to changes in economic assumptions. Fiscal and Monetary Policy Fiscal Policy: When this Administration took office in January 1993, it vowed to restore sound fiscal discipline. That goal has been amply achieved. In contrast to 1992, when the deficit reached a postwar record of $290 billion, representing 4.7 percent of GDP, the budget last year recorded a surplus of $69 billion, or 0.8 percent of GDP. The last time the budget was in surplus was in 1969; the last time the surplus was a larger share of GDP was in 1956. This year, the surplus is projected to rise to $79 billion, or 0.9 percent of GDP. The dramatic shift in the Nation’s fiscal position in the last six years from huge deficits to surpluses is unprecedented since the demobilization just after World War II. The historic improvement in the Nation’s fiscal position during this Administration is due to two landmark pieces of legislation, the Omnibus Budget Reconciliation Act of 1993 (OBRA) and the Balanced Budget Act of 1997 (BBA). OBRA, based on proposals made by the Administration soon after it came into office and signed into law in August of that year, set budget deficits on a downward path. The deficit reductions following OBRA have far exceeded predictions made at the time of its passage. OBRA was projected to reduce pre-Act deficits by $505 billion over the five years 1994–98. The total deficit reduction has been more than twice this—$1.2 trillion. In other words, OBRA and subsequent developments have enabled the Treasury to issue $1.2 trillion less debt than would have been required under previous estimates. While OBRA fundamentally altered the course of fiscal policy towards lower deficits, it was not projected to eliminate the deficit. Without further action, deficits were expected to begin to climb once again. To prevent this and bring the budget into permanent surplus, the Administration negotiated the Balanced Budget Act with the Congress in the summer of 1997. The BBA was not expected to produce surpluses until 2002, but like OBRA, the results of pursuing a policy of fiscal discipline far exceeded expectations. The budget moved into surplus in 1998, four years ahead of schedule. OBRA and the BBA together are estimated to have improved the budget balance compared with the preOBRA baseline by a cumulative total of $4.4 trillion over 1993–2002. Like the budget, the economy in recent years has far outperformed expectations. This is more than a coincidence. Lower deficits contribute to a healthy, sustainable expansion by reducing interest rates and boosting interest-sensitive spending in the economy. Rapid growth of business capital spending expands industrial capacity and boosts productivity growth. The additional capacity, in turn, prevents shortages and bottlenecks that might otherwise threaten to ignite inflation. Lower interest rates also raise equity prices, which increases household wealth, optimism, and spending. The added impetus to consumer spending creates new jobs and business opportunities. While the benefits of fiscal discipline have been widely recognized, the surprise in recent years has been the magnitude of the positive impact on the economy. Growth of production, jobs, income, and capital gains have all exceeded expectations. Consequently, Federal revenues in the past three years have been larger than projected—the socalled ‘‘revenue surprise.’’ Deficits have been smaller than expected and surpluses have occurred sooner. The outstanding economic performance during this Administration is proof positive of the lasting benefits of prudent fiscal policies. Monetary Policy: Monetary policy shares the credit for the economy’s excellent performance. During this expansion, the Federal Reserve appropriately tightened policy when inflation threatened to pick up, but eased when the expansion risked stalling out. In 1994 and early 1995, interest rates were raised when rapid growth threatened to cause inflationary pressures. During 1995 and early 1996, however, the Federal Reserve reduced interest rates because the expansion appeared to be slowing unduly at a time when higher inflation no longer threatened. From January 1996 until this past fall, monetary policy remained essentially unchanged; the sole adjustment was a one-quarter percentage point increase in the federal funds rate target in March 1997 to 51⁄2 percent. Last year, the spread of financial turmoil from foreign markets to our own threatened to undermine the hardwon health of the U.S. economy. The Russian government’s default on its debt in August led to a nearpanic in credit markets and a sell-off of equities here and abroad. Almost instantly there was a drastic revaluation of potential risks—not just for foreign loans, but for domestic credit as well. At the height of the flight to quality in early October, the spreads between yields on Treasury and private sector bonds widened dramatically. Market participants shunned all but the most liquid of credit instruments. The drying up of normal credit channels intensified with the near-failure of a large, highly leveraged U.S. hedge fund that had borrowed heavily from major banks. 1. ECONOMIC ASSUMPTIONS In response to these challenges, the Federal Reserve quickly shifted policy once more. It cut the Federal funds rate by one-quarter percentage point in September, followed by a cut of similar magnitude in both the funds rate and the discount rate in October and again in November. The drop in the funds rate target from 51⁄2 to 43⁄4 percent in just seven weeks, accompanied by a one-half percentage point cut in the discount rate to 41⁄2 percent, was the swiftest easing since 1991, when the economy was just emerging from recession. Market sentiment responded quickly to these actions. U.S. stock markets, which endured a short but sharp decline in late summer and early fall, rallied during the winter, reaching record levels in January, 1999. The S&P 500 was up 27 percent during 1998, a remarkable achievement after having more than doubled during the prior three years. Other market indexes staged impressive gains as well. During the last four years, the S&P and the narrower Dow-Jones Industrial Average have risen by 21⁄2 times. This is the best fouryear performance in the postwar period. By December, the Federal Reserve’s actions had restored normal relationships in most credit markets. Rates on short-term Treasury bills and commercial paper were about 70 basis points lower than in December 1997. The yield on 30-year Treasury bonds was about 90 basis points lower than a year earlier while yields on high-grade AAA-rated corporate bonds were 55 basis points lower. New bond and equity issuance, which had plummeted in the panic-ridden market atmosphere of October, recovered—even for less creditworthy companies. Some signs of heightened risk aversion remained, however. Interest rate spreads between highly rated instruments and more risky ones were still unusually large, although not as large as in October. The yield spread between below-investment grade corporate bonds and equivalent maturity Treasury bonds, for example, finished the year three percentage points higher than at the end of 1997. Although there were still strains in some markets, credit, so essential to a healthy economy, was generally widely available—and at favorable interest rates by historical standards. Consequently, at its December meeting, the Federal Reserve decided that no further easing was needed. The actions taken during the prior three months had accomplished its goal of restoring confidence. Recent Developments Real Growth: The economy expanded at a 3.7 percent annual rate over the first three quarters of 1998, and is estimated to have grown at a somewhat faster pace during the fourth quarter. This is the third year in a row of robust growth of around 4 percent annually. In each of these years, most forecasters had expected growth to slow to about 21⁄4 percent per year, around the pace that the economy is generally believed capable of sustaining on a long-run basis. 5 The fastest growing sector last year was again business spending on new equipment: up at a 16 percent annual rate during the first three quarters of the year, it is estimated to have risen at a double-digit rate in the fourth quarter as well. The biggest gains continued to be for information processing and related equipment, but businesses invested heavily in other forms of equipment as well. Investment in new structures, in contrast, edged down during 1998. This exceptionally strong growth of spending for new equipment boosted productivity and expanded industrial capacity to meet current and future demands. Overall industrial capacity rose by more than 5 percent in each of the past four years; the last time capacity grew this rapidly was in the late 1960s. The extra capacity has helped keep inflation low by easing the bottlenecks that might otherwise have developed. In the fourth quarter of 1998, the manufacturing operating rate was below its long-term average, even though labor markets were much tighter than usual. Growth last year was also supported by robust household spending. Low unemployment, low interest rates, rising real incomes, extraordinary capital gains, and record levels of consumer optimism have provided households with the resources and willingness to spend heavily, especially on discretionary, postponable purchases. Overall consumer spending after adjustment for inflation rose at a 5.4 percent annual rate during the first three quarters of the year, and continued at a brisk pace in the fourth quarter. Growth of consumer spending last year was the fastest in 15 years. The surge in consumer spending last year outstripped even the robust growth of disposable personal income. As a result, the saving rate edged down during the year, and entered negative territory in the fourth quarter. Not since the 1930s has the household saving rate been negative. Then, however, it was sign of extreme stress: incomes were shrinking faster than spending. Now, it is the result of economic success: soaring stock market wealth has enabled households to feel confident boosting spending knowing they have made unexpectedly large capital gains. The same factors spurring consumption pushed new and existing home sales during 1998 to their highest level since record-keeping began. The homeownership rate reached a record 66.8 percent in the third quarter. Buoyant sales and low inventories of unsold homes provided a strong incentive for builders to start new construction. Housing starts rose last year to the highest level since 1987. Residential investment, after adjustment for inflation, increased at a 13.5 percent annual rate during the first three quarters of the year, and is estimated to have risen at a double-digit pace in the fourth quarter. The growth of residential investment last year was the strongest since 1992, when homebuilding was just emerging from recession. Government purchases, on balance, made very little contribution to GDP growth last year. Federal government spending in GDP after adjustment for inflation edged down at a 1.2 percent annual rate during the 6 first three quarters, about the same contraction as during 1997. By the third quarter of last year, Federal government spending in GDP was 12 percent lower than when the Administration took office. State and local spending in GDP rose at a moderate 2.3 percent rate during the first three quarters of 1998, offsetting the restraint on growth from the Federal sector. In recent years, States and localities have increased their spending only modestly, despite the availability of unexpectedly large budget surpluses resulting from strongerthan-expected revenues. The foreign sector was the primary restraint on growth last year, as it was the year before. Exports of goods and services after adjustment for inflation shrank last year (the first time that has occurred since 1985) as several economies abroad contracted—including Japan, the world’s second largest economy. In addition, the 21 percent rise in the dollar from the end of 1996 to October 1998 stimulated imports into the United States. The widening of the net export deficit during the first three quarters of the year trimmed 13⁄4 percentage point off of real GDP growth. The negative contribution from the trade sector was less pronounced during the second half of the year than the first, suggesting that the worst of the adverse trade impact may be over. Labor Markets: The performance of the labor market last year far exceeded most predictions. At the start of the year, most forecasters had expected growth to slow and the unemployment rate to rise slightly. Instead, the economy expanded at about the same rapid pace as during 1997, driving the unemployment rate down to 4.3 percent by December. When this Administration took office, the unemployment rate was 7.3 percent. All demographic groups, and especially minorities, have experienced a large decline in unemployment. Forty states had unemployment rates of 5.0 percent or less in November; only two had rates above 6.0 percent. The Nation’s payrolls expanded by a sizeable 2.9 million jobs last year. Unlike previous years, employment gains were not widespread across industries. Mining and manufacturing, especially vulnerable to developments in international trade, lost jobs. This was more than offset numerically by job growth by the private service sector, construction, state and local government, and even the Federal Government (because of its temporary hiring in preparation for the decennial census). The abundance of employment opportunities pushed the labor force participation rate and employment/population ratio up the highest levels on record. Inflation: Despite rapid growth and the low unemployment rate, inflation remained low last year, and even declined by some measures. The Consumer Price Index (CPI) and the CPI excluding food and energy increased about the same rate in 1998 as in 1997. The core CPI excluding food and energy rose just 2.4 percent last year, nearly matching 1997’s 2.2 percent, which was the slowest rise since 1965. Because of falling en- ANALYTICAL PERSPECTIVES ergy prices, the total CPI rose even less, 1.6 percent, about the same as the 1.7 percent of 1997. Progress in reducing inflation is even more impressive measured by the broadest indicator, the GDP chain-weighted price index. It rose just 0.9 percent at an annual rate during the first three quarters of 1998, 0.8 percentage point less than during the four quarters of 1997. The last time aggregate inflation was this low was in 1961. The favorable inflation performance was the result of several factors: intense foreign competition, low unit labor costs, and perhaps structural changes in the link between unemployment and inflation. The rise in the dollar has reduced the costs of imported materials and intensified price competition from imports. Non-oil import prices fell 3.1 percent last year, while imported oil prices tumbled 40 percent. Export prices of goods (a component of the GDP price index) fell 3.5 percent, as American exporters trimmed prices to remain competitive abroad. Despite low unemployment, the increase in hourly earnings and the broader measures of compensation were not much different during 1998 than the prior year. Moreover, robust investment in new equipment contributed to unusually strong productivity growth for this stage of an expansion, helping to restrain inflation by offsetting the gains in labor compensation. Unit labor costs rose at only a 1.8 percent annual rate during the first three quarters of 1998, down from 2.0 percent during 1997. The absence of inflationary pressures has implications for the estimate of the level of unemployment that is consistent with stable inflation. This threshold has been called the NAIRU, or ‘‘nonaccelerating inflation rate of unemployment.’’ Economists have been lowering their estimates of NAIRU in recent years in keeping with the accumulating experience that lower unemployment has not led to higher inflation, even after taking into account the influence of temporary factors. The economic projections for this Budget assume that NAIRU is in a range centered on 5.3 percent. That is 0.1 percentage point less than estimated in the 1999 Budget assumptions and 0.4 percentage point less than in the 1997 Budget. Most private forecasters have also reduced their estimates of NAIRU in recent years. By the end of 1998, the unemployment rate was about one percentage point below the current mainstream estimate of NAIRU. The Administration forecast for real growth over the next three years implies that unemployment will return to 5.3 percent by the middle of 2001. Statistical Issues The U.S. statistical agencies endeavor to measure accurately the economy’s performance, but the U.S. economy is a moving target; statistical agencies must constantly improve their measurement tools just to keep up with rapid structural changes. It is not surprising, therefore, that concerns have been raised about possible 1. ECONOMIC ASSUMPTIONS mismeasurement in recent years, especially of real GDP growth and of inflation. Real Growth: In a perfect statistical world, the value of output would equal the value of income generated in its production: GDP would match Gross Domestic Income (GDI). However, because the series are estimated from different source data, each with its own gaps and inconsistencies, the two measures are hardly ever identical. What is particularly unusual now is the wide and growing difference between product and income measures. This ‘‘statistical discrepancy’’ (defined as aggregate output minus aggregate income) was –$102 billion in the third quarter of 1998, a record –1.2 percent of nominal GDP. By comparison, in the first quarter of 1995, the statistical discrepancy was nearly zero, and two years earlier, in the first quarter of 1993, it was a positive $71 billion, or 1.1 percent of GDP. A swing of this magnitude means that during the past five and a half years, the annual average real growth rate measured from the familiar GDP output side has been about 0.4 percentage point less than the growth rate measured from the income side. During the first three quarters of last year, the divergence between the two measures of real growth remained near this magnitude. It is possible that the incorporation of more complete source data in the annual and benchmark revisions to the national accounts will eventually reduce the size of the statistical discrepancy. That is what happened last July, but even after that revision, the discrepancy in the third and fourth quarters of 1997 was still a sizeable –0.8 percent of GDP. The absence of a clear picture of the economy’s actual growth performance is a cause for some concern. Any estimate of potential growth depends on an estimate of trend productivity growth, which itself depends on recent data on actual growth. When there is a growing divergence between product and income measures, there is a comparable divergence in estimates of the productivity trend. For example, from the last cyclical real GDP peak in the second quarter of 1990 to the third quarter of 1998, labor productivity growth has increased at a 1.3 percent annual rate according to the official productivity statistics which measure output growth from the product side. Productivity growth measured from the income side, however, is at a 1.5 percent rate. While faster growth of trend productivity and potential GDP of 0.2 percentage point per year may seem trivial, cumulated over the 10-year budget horizon— or more significantly over the 75 years of the longrun projections made in Chapter 2 of this Analytical Perspectives volume—the additional output made possible by higher productivity growth can imply tens or even hundreds of billions of dollars of additional income in the economy. It is unclear whether the product or the income side provides the more accurate measure of growth. The Bureau of Economic Analysis (BEA) recognizes the shortcomings of both measures but believes that GDP 7 is a more reliable measure than GDI (see the Survey of Current Business, August 1997, page 19). Other experts believe that some figure between the two measures may be more accurate. There is circumstantial evidence to suggest that growth may be faster than shown by the traditional GDP output measure. The recent combination of low inflation and high profits suggests that productivity growth may be stronger than reported from the output side. Moreover, the unexpected strength of Treasury receipts in the last three years suggests that the output measure, and even the income measure, may be too low. While some of the higher receipts are from capital gains generated by the booming stock market, which are not included in the national income accounts (because they arise from asset price revaluations rather than from current production), capital gains do not fully account for the surge. The Administration’s budget assumptions project trend productivity growth of 1.3 percent per year, the average measured pace since GDP reached its last peak in the second quarter of 1990. It is possible that trend productivity growth may be somewhat faster, not only because of the faster growth of gross domestic income than gross domestic product in recent years, but also because the next benchmark GDP revision to the national accounts may incorporate improvements to the measurement of consumer prices that would lower GDP inflation slightly during the first half of the 1990s and raise real GDP growth by a comparable amount. In last July’s annual revision covering the years 1995–1998, the Bureau of Economic Analysis took a step in this direction by switching to a geometric mean formula for the calculation of the consumer price measures used to deflate personal consumption expenditures. This lowered overall GDP inflation by almost 0.2 percentage points per year, and thereby boosted measured nonfarm output and productivity growth by 0.2 percentage points annually. The next benchmark GDP revisions, which will be published in October 1999, will incorporate this methodological change going back at least to 1990. All other things equal, this would be expected to raise slightly productivity growth measured from the last cyclical peak. However, because the benchmark revisions will include many other methodological and source data improvements, it is not possible to know how much and in what direction the currently measured productivity trend will be altered. Therefore, the budget projections are based on the prudent course of assuming a continuation of the productivity trend as measured by the statistics now available. The uncertainty surrounding actual growth and its trend makes it more difficult to determine appropriate monetary policy. From a budgetary perspective, estimates of receipts and expenditures are more uncertain because they are dependent on the forecast for growth. As shown in Table 1–6, ‘‘Sensitivity of the Budget to Economic Assumptions,’’ even small errors in projecting real GDP growth can have a significant effect on the budget balance cumulated over several years. 8 Inflation: Accurate measurement of inflation has become increasingly important in recent years, even as inflation has been brought under control. Eliminating biases of even a few tenths of a percentage point a year can be important relative to a goal of price stability when inflation is low, while it may have less significance when inflation is higher. A few years ago, questions were raised about the magnitude of bias in the Consumer Price Index (CPI). In December 1996, the Advisory Commission to Study the Consumer Price Index, appointed by the Senate Finance Committee, reported that the index overstated the actual cost of living by 1.1 percentage points per year; other experts believed that the magnitude of empirically demonstrated biases was less. The Bureau of Labor Statistics (BLS) has made important methodological improvements beginning in 1995 that have significantly reduced any overstatement of inflation as measured by the CPI. Taken together, these changes are estimated to result in a 0.7 percentage point slower annual rise in the CPI by 1999 compared with the methodologies used in 1994. The changes instituted from 1995–1998 are estimated to have slowed the growth of the CPI by 0.5 percentage point per year. These improvements include correction of a problem in rotating new stores into the survey, a better measure of prices for hospital services and computers, and a more accurate estimate of the equivalent rent attributed to owner-occupied housing. In addition, the BLS updated the expenditure weights used in the CPI from a 1982–84 basis to 1993–95 weights, introduced a more accurate geographic sample based on the 1990 decennial census, and redefined the groupings of items. (For a fuller description of these changes, see pages 7–8 in last year’s Analytical Perspectives.) The changes introduced this year are expected to reduce CPI growth by another 0.2 percentage point per year. Two methodological improvements are being instituted this year. Beginning with the January CPI, items will be sampled on a product rather than a geographical basis. This switch will allow more frequent sampling of categories with rapidly changing product lines, such as consumer electronics. An even more important change is the replacement of the fixed-weighted Laspeyres formula that has been used in the CPI by a geometric mean formula for combining individual price quotations within certain components of the index. BLS is applying this improvement to categories where there are deemed to be substantial possibilities for substitution among items within the category—for example, different varieties of apples. In total, the categories using geometric means account for about 60 percent of the overall weight of the CPI. A CPI calculated using geometric means more closely approximates a cost-of-living index. Unlike the fixedweighted aggregation, the geometric mean formula allows for some shifts in consumer spending patterns in response to changes in relative prices within categories of goods and services. ANALYTICAL PERSPECTIVES Because the CPI is used to deflate some nominal spending components of GDP, a slower rise in the CPI translates directly into a faster measured rise in real GDP and productivity growth. As noted in the discussion of real GDP in the prior section, the BEA recently applied the geometric mean formula to the prices used to deflate nominal personal consumption expenditures. As a result, measured productivity growth and real GDP growth in recent years were raised by almost 0.2 percentage point per year. The improved measurement of inflation, both in the CPI and the national income accounts, has important implications for the budget. Slower growth of the CPI means that outlays for programs with cost-of-living adjustments tied to this index or its components—such as Social Security, Supplemental Security Income (SSI), retirement payments for railroad and Federal employees, and Food Stamps—will rise at a slower pace more in keeping with true inflation than they would have without these improvements. In addition, slower growth of the CPI will raise the growth of receipts: personal income tax brackets, the size of the personal exemptions, and eligibility thresholds for the Earned Income Tax Credit (EITC) will rise more slowly because they are also indexed to the CPI. Hence, the methodological improvements made in recent years act on both the outlays and receipts sides of the budget to increase the size of budget surpluses. Economic Projections The economy’s strong performance last year—and, indeed, over the last six years—and the maintenance of sound fiscal and monetary policies raise the possibility that actual economic developments may even be better than assumed—as has been the case in recent years. Nonetheless, it is prudent to base budget estimates on a conservative set of economic assumptions close to the consensus of private-sector forecasts. The economic assumptions summarized in Table 1–1 are predicated on the adoption of the policies proposed in this budget. The swing in the fiscal position from deficit to surplus is expected to contribute to continued favorable economic performance. Federal Government surpluses reduce interest rates, stimulate private sector investment in new plant and equipment, and help keep inflation under control. The Federal Reserve is assumed to continue to pursue successfully the twin goals of keeping inflation low while promoting growth. The economy is likely to continue to grow during the next few years, although at a more moderate pace than during 1998. While job opportunities are expected to remain plentiful, the unemployment rate is likely to rise gradually to a level consistent with stable inflation over the longer horizon. New job creation will boost incomes and consumer spending and keep confidence at a high level. Continued low inflation will enable monetary policy to support economic growth. Growth, in turn, will further improve the budget balance. 1. 9 ECONOMIC ASSUMPTIONS Table 1–1. ECONOMIC ASSUMPTIONS 1 (Calendar years; dollar amounts in billions) Actual 1997 Projections 1998 1999 2000 2001 2002 2003 2004 8,111 7,270 111.6 8,497 7,539 112.7 8,833 7,717 114.4 9,199 7,872 116.8 9,582 8,029 119.3 10,004 8,208 121.8 10,456 8,404 124.4 10,930 8,606 127.0 5.6 3.8 1.7 4.5 3.5 0.9 4.0 2.0 1.9 4.2 2.0 2.1 4.1 2.0 2.1 4.5 2.4 2.1 4.5 2.4 2.1 4.5 2.4 2.1 5.9 3.9 1.9 4.8 3.7 1.0 4.0 2.4 1.5 4.1 2.0 2.1 4.2 2.0 2.1 4.4 2.2 2.1 4.5 2.4 2.1 4.5 2.4 2.1 Incomes, billions of current dollars: Corporate profits before tax .......................................................................................................... Wages and salaries ....................................................................................................................... Other taxable income 2 .................................................................................................................. 734 3,890 1,717 721 4,146 1,763 724 4,349 1,815 739 4,526 1,863 765 4,701 1,921 787 4,892 1,980 826 5,106 2,051 867 5,331 2,126 Consumer Price Index (all urban): 3 Level (1982–84 = 100), annual average ........................................................................................ Percent change, fourth quarter over fourth quarter ..................................................................... Percent change, year over year ................................................................................................... 160.6 1.9 2.3 163.1 1.6 1.6 166.7 2.3 2.2 170.6 2.3 2.3 174.5 2.3 2.3 178.5 2.3 2.3 182.6 2.3 2.3 186.8 2.3 2.3 4.7 5.0 4.6 4.6 4.9 4.8 5.1 5.0 5.3 5.3 5.3 5.3 5.3 5.3 5.3 5.3 3.0 3.0 2.8 2.8 3.6 3.6 4.4 4.4 3.9 3.9 3.9 3.9 3.9 3.9 3.9 3.9 5.1 6.4 4.8 5.3 4.2 4.9 4.3 5.0 4.3 5.2 4.4 5.3 4.4 5.4 4.4 5.4 Gross Domestic Product (GDP): Levels, dollar amounts in billions: Current dollars ............................................................................................................................... Real, chained (1992) dollars ......................................................................................................... Chained price index (1992 = 100), annual average ...................................................................... Percent change, fourth quarter over fourth quarter: Current dollars ............................................................................................................................... Real, chained (1992) dollars ......................................................................................................... Chained price index (1992 = 100) ................................................................................................. Percent change, year over year: Current dollars ............................................................................................................................... Real, chained (1992) dollars ......................................................................................................... Chained price index (1992 = 100) ................................................................................................. Unemployment rate, civilian, percent: Fourth quarter level ....................................................................................................................... Annual average .............................................................................................................................. Federal pay raises, January, percent: Military 4 .......................................................................................................................................... Civilian 5 ......................................................................................................................................... Interest rates, percent: 91-day Treasury bills 6 ................................................................................................................... 10-year Treasury notes ................................................................................................................. 1 Based on information available as of early December 1998. Rent, interest, dividend and proprietors components of personal income. 3 Seasonally adjusted CPI for all urban consumers. Two versions of the CPI are now published. The index shown here is that currently used, as required by law, in calculating automatic adjustments to individual income tax brackets. Projections reflect scheduled changes in methodology. 4 Beginning with the 1999 increase, percentages apply to basic pay only; adjustments for housing and subsistence allowances will be determined by the Secretary of Defense. 5 Overall average increase, including locality pay adjustments. 6 Average rate (bank discount basis) on new issues within period. 2 Real GDP, Potential GDP and Unemployment: Over the next three years, real GDP is expected to rise 2.0 percent per year. This shift to more moderate growth recognizes that by mainstream assumptions, growth has exceeded the pace that can be maintained on a sustained basis, and that this could eventually result in upward pressures on inflation. More moderate growth has been expected for this reason. Also, recessions in Asia and slow growth elsewhere are expected to restrain U.S. growth again this year, albeit not as much as during 1998. From 2001–2007, growth is expected to average a slightly faster 2.4 percent per year—the Administration’s estimate of the economy’s potential growth rate. In 2008, potential growth is projected to slow to 2.3 percent to reflect the foreseeable demographic trend toward slower growth of the workforce as the baby-boomers begin to retire. The net export component of GDP is expected to restrain real growth by about half as much as during 1998. Exports are expected to rise, rather than contract as they did in 1998, and import growth is likely to be somewhat slower than last year as our domestic demand slows. Beginning with 2000, the foreign sector is not expected to make a large contribution, positive or negative, to overall growth. As has been the case throughout this expansion, during the next six years business fixed investment is expected to be the fastest growing component of GDP. Although residential investment is also expected to benefit from low mortgage rates and strong demand for second homes for vacation or retirement, the high level of housing starts in recent years and underlying demographic trends may tend to reduce future growth somewhat. Consumer spending, especially on durable goods, is also likely to moderate from the rapid pace of 1998. The fundamental factors supporting consumer spending are likely to remain favorable, although not quite to the same extent as during 1998. The government component of GDP will grow slowly through 2004. A decline in Federal consumption and gross investment is projected to be offset by moderate growth in State and local spending. Potential GDP growth of 2.4 percent on average through 2007 can be decomposed into the trend growth 10 of productivity, 1.3 percent per year, plus the growth of the labor force, estimated at 1.1 percent annually. The Administration’s labor force projection assumes that the population of working age will grow 1.0 percent per year and that the labor force participation rate will edge up 0.1 percent per year. Both the labor force and participation rate assumptions are lower than recent experience. The participation rate has risen 0.2 percent per year since 1993, as falling unemployment and rapidly expanding job opportunities have induced job-seeking. With the labor force participation rate and employment/population ratio already at post-World War II highs last year, it is prudent to project a slower rise in coming years. In addition, the female participation rate, which had risen sharply during much of the postwar period, grew much more slowly during the 1990s, and this is forecast to be reflected in future growth rates. The real GDP growth projection of 2.0 percent through 2001 is consistent with a gradual rise in the unemployment rate to 5.3 percent. Unemployment is then projected to average 5.3 percent from 2001 onward, when real GDP growth reverts on average to the Administration’s estimate of the economy’s potential growth rate. Inflation: With unemployment expected to be slightly below the NAIRU during the next three years, inflation is projected to creep up. The CPI is projected to increase 2.3 percent during this and the subsequent years of the forecast; the GDP chain-weighted price index is projected to increase 2.1 percent annually beginning in 2000. The 0.2 percentage point difference between the two inflation measures is narrower than the 0.5 percentage point of 1998, in part because BLS will introduce the geometric means formula into the CPI this year, which will slow the growth in the index by about 0.2 percentage point annually. As discussed above, this change will not affect the GDP price index because BEA has already incorporated this improvement. Despite the relatively tight labor market in the next few years, the inflation rate is projected to remain low, partly because of two temporary factors. The rise in the dollar is expected to hold down import prices and intensify price competition from imported goods and services. In addition, wide profit margins provide a cushion that will enable firms to absorb cost increases without having to pass them on fully into higher prices. Moreover, the methodological improvements to the CPI introduced this year also will slow the rise in the CPI. Interest Rates: The assumptions, which were finalized in early December, project stable short-term rates and a slight rise in long-term interest rates. The rise at the long end of the maturity spectrum is about the same as the increase in the CPI. By 2002, the 91day Treasury bill rate is expected to be 4.4 percent, close to December’s average; the yield on the 10-year Treasury bond is projected to be 5.3 percent, compared with 4.7 percent in December. ANALYTICAL PERSPECTIVES Incomes: The moderating of real growth during the projection horizon is expected to shift the distribution of national income slightly, augmenting somewhat the share going to compensation, while trimming the unusually high profits share in GDP. The personal interest income share is also projected to decline as interest rates remain historically low and as households hold less Federal government debt because of the projected budget surpluses. On balance, total taxable income is projected to decline gradually as a share of GDP. Comparison with CBO The Congressional Budget Office (CBO) prepares the economic projections used by Congress in formulating budget policy. In the executive branch, this function is performed jointly by the Treasury, the Council of Economic Advisers (CEA), and the Office of Management and Budget (OMB). It is natural that the two sets of economic projections be compared with one another, but there are several important differences, along with the similarities, that should be kept in mind: The Administration’s projections always assume that the President’s policy proposals in the budget will be adopted in full. In contrast, CBO normally assumes that current law will continue to hold; thus, it makes a ‘‘pre-policy’’ projection. In recent years, and currently, CBO has made economic projections based on a fiscal policy similar to the budget’s. Both CBO and the Administration assume that maintaining budget surpluses would have significant macroeconomic effects, especially for interest rates and the distribution of income. The two sets of projections are often prepared at different times. The Administration’s projections must be prepared in early December, months ahead of the release of the budget. Some of the differences in the Administration’s and CBO’s near-term forecasts, therefore, may be due to the availability of more recent data to CBO. Timing differences are much less likely to play an important role in any differences in outyear projections, however. Table 1–2 presents a summary comparison of the two sets of projections. Briefly, the Administration and CBO projections are very similar for all the major variables affecting the budget outlook: Real GDP: The projections of real GDP growth are quite similar; both the Administration and CBO project that real GDP will grow at an average annual rate of 2.2 percent over the 1999–2004 period. Inflation: Both the Administration and CBO expect inflation to continue at a slow, steady rate over the next several years. For the chain-weighted GDP price index, both predict that inflation will be 2.1 percent yearly; CBO expects the annual rate of change in the CPI to be about 0.3 percentage point higher than the Administration. Unemployment: CBO projects unemployment to rise from its current level to 5.7 percent. The Administra- 1. 11 ECONOMIC ASSUMPTIONS Table 1–2. COMPARISON OF ADMINISTRATION AND CBO ECONOMIC ASSUMPTIONS (Calendar years; percent) Projections 1999 2000 2001 2002 2003 2004 1 Real GDP (chain-weighted): CBO January ................................................................. 2000 Budget .................................................................. 1.8 2.0 1.9 2.0 2.3 2.0 2.4 2.4 2.5 2.4 2.4 2.4 Chain-weighted GDP Price Index: 1 CBO January ................................................................. 2000 Budget .................................................................. 2.1 1.9 2.0 2.1 2.2 2.1 2.1 2.1 2.1 2.1 2.1 2.1 Consumer Price Index (all-urban): 1 CBO January ................................................................. 2000 Budget .................................................................. 2.7 2.3 2.6 2.3 2.6 2.3 2.6 2.3 2.6 2.3 2.6 2.3 Unemployment rate: 2 CBO January ................................................................. 2000 Budget .................................................................. 4.6 4.8 5.1 5.0 5.4 5.3 5.6 5.3 5.7 5.3 5.7 5.3 Interest rates: 2 91-day Treasury bills: CBO January ............................................................ 2000 Budget .............................................................. 4.5 4.2 4.5 4.3 4.5 4.3 4.5 4.4 4.5 4.4 4.5 4.4 10-year Treasury notes: CBO January ............................................................ 2000 Budget .............................................................. 5.1 4.9 5.3 5.0 5.4 5.2 5.4 5.3 5.4 5.4 5.4 5.4 Taxable income (share of GDP): 3 CBO January ................................................................. 2000 Budget .................................................................. 77.8 78.0 77.1 77.5 76.9 77.1 76.6 76.6 76.5 76.4 76.3 76.1 1 2 3 Percent change, fourth quarter over fourth quarter. Annual averages, percent. Taxable personal income plus corporate profits before tax. tion projects that the unemployment rate will average a slightly lower 5.3 percent. Interest rates: The Administration and CBO have very similar paths for long- and short-term interest rates. Income distribution: The Administration and CBO have similar projections for total taxable income shares of GDP. Both CBO and the Administration expect a shift of income from interest to corporate profits as a result of the sustained lower interest rates resulting from continued budget surpluses. Both project a similar secular decline in the total taxable income share. Impact of Changes in the Economic Assumptions The economic assumptions underlying this budget are similar to those of last year. Both budgets anticipated that achieving a fundamental shift in fiscal posture from large deficits to surpluses would result in a significant decline in interest rates, which would serve to extend the economic expansion at a moderate pace while helping to maintain low, steady rates of inflation and unemployment. The shift to budget surpluses and the ensuing lower interest rates were also expected to shift the composition of income from interest to profits. This would have favorable effect on receipts and the budget balance, because profits are on average taxed more heavily than interest income. The changes in the economic assumptions since last year’s budget have been relatively modest, as Table 1–3 shows. The differences are primarily the result of economic performance in 1998 that has, once again, proven more favorable than was anticipated at the beginning of last year. Economic growth was stronger than expected in 1998, while inflation and unemployment were lower. Because of this favorable performance, the projected annual averages for the unemployment rate and GDP price index have again been reduced slightly this year. At the same time, interest rates are assumed in this budget to remain near their current low levels. Interest rates are already lower than the levels to which they were assumed to decline eventually in last year’s forecast. 12 ANALYTICAL PERSPECTIVES Table 1–3. COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 1999 AND 2000 BUDGETS (Calendar years; dollar amounts in billions) Nominal GDP: 1999 Budget assumptions 1 ............................... 2000 Budget assumptions ................................. Real GDP (percent change): 2 1999 Budget assumptions ................................. 2000 Budget assumptions ................................. GDP price index (percent change): 2 1999 Budget assumptions ................................. 2000 Budget assumptions ................................. Consumer Price Index (percent change): 2 1999 Budget assumptions ................................. 2000 Budget assumptions ................................. Civilian unemployment rate (percent): 3 1999 Budget assumptions ................................. 2000 Budget assumptions ................................. 91-day Treasury bill rate (percent): 3 1999 Budget assumptions ................................. 2000 Budget assumptions ................................. 10-year Treasury note rate (percent): 3 1999 Budget assumptions ................................. 2000 Budget assumptions ................................. 1 2 3 1998 1999 2000 2001 2002 2003 2004 8,473 8,497 8,818 8,833 9,189 9,199 9,596 9,582 10,045 10,004 10,508 10,456 10,999 10,930 2.0 3.5 2.0 2.0 2.0 2.0 2.3 2.0 2.4 2.4 2.4 2.4 2.4 2.4 2.0 0.9 2.1 1.9 2.2 2.1 2.2 2.1 2.2 2.1 2.2 2.1 2.2 2.1 2.2 1.6 2.2 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 4.9 4.6 5.1 4.8 5.3 5.0 5.4 5.3 5.4 5.3 5.4 5.3 5.4 5.3 5.0 4.8 4.9 4.2 4.8 4.3 4.7 4.3 4.7 4.4 4.7 4.4 4.7 4.4 5.9 5.3 5.8 4.9 5.8 5.0 5.7 5.2 5.7 5.3 5.7 5.4 5.7 5.4 Adjusted for July 1998 NIPA revisions. Fourth quarter-to-fourth quarter. Calendar year average. The net effects of these modifications in the economic assumptions on the budget are shown in Table 1–4. The largest effects come from higher receipts during 1999–2004. In all years through 2004, there are lower outlays for interest due to the unexpectedly large fall Table 1–4. in interest rates, and lower outlays for cost-of-living adjustments to Federal programs due to lower 1998 inflation. The change in economic assumptions since last year increases budget surpluses by $40 billion to $50 billion a year. EFFECTS ON THE BUDGET OF CHANGES IN ECONOMIC ASSUMPTIONS SINCE LAST YEAR (In billions of dollars) Budget totals under 1999 Budget economic assumptions and 2000 Budget policies: Receipts ......................................................................................... Outlays ........................................................................................... 1999 2000 2001 2002 2003 2004 1,778.4 1,743.1 1,857.0 1,789.0 1,909.0 1,824.8 1,988.9 1,846.3 2,060.2 1,921.0 2,154.5 1,987.8 35.4 68.1 84.1 142.6 139.2 166.8 Surplus .................................................................................. Changes due to economic assumptions: Receipts ......................................................................................... Outlays: Inflation ...................................................................................... Unemployment ........................................................................... Interest rates .............................................................................. Interest on changes in borrowing ............................................. 27.9 25.9 24.4 18.1 14.8 11.0 –4.9 –3.5 –6.4 –1.2 –6.3 –2.4 –11.0 –3.6 –6.6 –1.6 –-11.4 –6.1 –6.9 –0.7 –10.0 –8.4 –7.3 –0.9 –9.2 –10.6 –7.9 –1.0 –8.3 –12.7 Total, outlay decreases (–) ................................................... –16.0 –23.3 –25.6 –26.0 –28.1 –29.9 Increase in surplus ............................................................... Budget totals under 2000 Budget economic assumptions and policies: Receipts ......................................................................................... Outlays ........................................................................................... 43.9 49.2 50.0 44.1 42.9 40.9 1,806.3 1,727.1 1,883.0 1,765.7 1,933.3 1,799.2 2,007.1 1,820.3 2,075.0 1,893.0 2,165.5 1,957.9 Surplus .................................................................................. 79.3 117.3 134.1 186.7 182.0 207.6 1. 13 ECONOMIC ASSUMPTIONS Structural vs. Cyclical Balance When the economy is operating above potential as it is currently estimated to be, receipts are higher than they would be if resources were less fully employed, and outlays for unemployment-sensitive programs (such as unemployment compensation and food stamps) are lower. As a result, the deficit is smaller or the surplus Table 1–5. is larger than it would be if unemployment were at the NAIRU. The portion of the surplus or deficit that can be traced to this factor is called the cyclical surplus or deficit. The remainder, the portion that would remain with unemployment at the NAIRU (consistent with a 5.3 percent unemployment rate), is called the structural surplus or deficit. ADJUSTED STRUCTURAL BALANCE (In billions of dollars) 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Unadjusted deficit (–) or surplus ............................ Cyclical component ............................................ –290.4 –75.0 –255.0 –66.2 –203.1 –38.1 –163.9 –16.5 –107.4 –7.8 –21.9 12.4 69.2 34.3 79.3 29.4 117.3 16.7 134.1 6.6 186.7 0.3 182.0 .......... 207.6 .......... Structural deficit (–) or surplus ............................... Deposit insurance outlays .................................. –215.4 –2.3 –188.9 –28.0 –165.0 –7.6 –147.4 –17.9 –99.6 –8.4 –34.3 –14.4 35.0 –4.4 49.9 –5.0 100.6 –2.3 127.5 –1.8 186.5 –1.3 182.0 –* 207.6 0.8 Adjusted structural deficit (–) or surplus ................ –217.7 –216.9 –172.6 –165.3 –108.0 –48.7 30.6 44.8 98.3 125.7 185.1 182.0 208.5 Changes in the structural balance give a better picture of the impact of budget policy on the economy than does the unadjusted budget balance. The level of the structural balance also gives a clearer picture of the stance of fiscal policy, because this part of the surplus or deficit will persist even when the economy achieves permanently sustainable operating levels. In the early 1990s, large swings in net outlays for deposit insurance (the S&L bailouts) had substantial impacts on deficits, but had little concurrent impact on economic performance. It therefore became customary to remove deposit insurance outlays as well as the cyclical component of the surplus or deficit from the actual surplus or deficit to compute the adjusted structural balance. This is shown in Table 1–5. For the period 1998 through mid-2001, the unemployment rate is slightly below the estimated NAIRU of 5.3 percent, resulting in cyclical surpluses. Thereafter, unemployment is projected to equal the NAIRU, so the cyclical component of the surplus vanishes. Deposit insurance net outlays are relatively small and do not change greatly from year to year. The adjusted structural surplus or deficits in this budget display much the same pattern of year-to-year changes as the actual deficits. Two significant points are illustrated by this table. First, of the $360 billion swing in the actual budget balance between 1992 and 1998 (from a $290 billion deficit to a $69 billion surplus), 30 percent ($109 billion) resulted from cyclical improvement in the economy. The rest of the reduction stemmed primarily from policy actions—mainly those in the Omnibus Budget Reconciliation Act of 1993, which reversed a projected continued steep rise in the deficit and set the stage for the remarkable cyclical improvement that has occurred. Second, the structural surplus is expected to rise substantially over the projection horizon—in part due to the effects of the Balanced Budget Act of 1997. Sensitivity of the Budget to Economic Assumptions Both receipts and outlays are affected by changes in economic conditions. This sensitivity seriously complicates budget planning, because errors in economic assumptions lead to errors in the budget projections. It is therefore useful to examine the implications of alternative economic assumptions. Many of the budgetary effects of changes in economic assumptions are fairly predictable, and a set of rules of thumb embodying these relationships can aid in estimating how changes in the economic assumptions would alter outlays, receipts, and the surplus. Economic variables that affect the budget do not usually change independently of one another. Output and employment tend to move together in the short run: a high rate of real GDP growth is generally associated with a declining rate of unemployment, while moderate or negative growth is usually accompanied by rising unemployment. In the long run, however, changes in the average rate of growth of real GDP are mainly due to changes in the rates of growth of productivity and labor supply, and are not necessarily associated with changes in the average rate of unemployment. Inflation and interest rates are also closely interrelated: a higher expected rate of inflation increases interest rates, while lower expected inflation reduces rates. Changes in real GDP growth or inflation have a much greater cumulative effect on the budget over time if they are sustained for several years than if they last for only one year. Highlights of the budget effects of the above rules of thumb are shown in Table 1–6. If real GDP growth is lower by one percentage point in calendar year 1999 only and the unemployment rate rises by one-half percentage point, the fiscal 1999 surplus would decrease by $9.8 billion; receipts in 1999 would be lower by about $8.0 billion, and outlays would 14 be higher by about $1.8 billion, primarily for unemployment-sensitive programs. In fiscal year 2000, the receipts shortfall would grow further to about $17.2 billion, and outlays would increase by about $6.1 billion relative to the base, even though the growth rate in calendar 2000 equals the rate originally assumed. This is because the level of real (and nominal) GDP and taxable incomes would be permanently lower, and unemployment higher. The budget effects (including growing interest costs associated with higher deficits or smaller surpluses) would continue to grow slightly in later years. The budget effects are much larger if the real growth rate is assumed to be one percentage point less in each year (1999–2004) and the unemployment rate to rise one-half percentage point in each year. With these assumptions, the levels of real and nominal GDP would be below the base case by a growing percentage. The budget balance would be worsened by $163.3 billion relative to the base case by 2004. The effects of slower productivity growth are shown in a third example, where real growth is one percentage point lower per year while the unemployment rate is unchanged. In this case, the estimated budget effects mount steadily over the years, but more slowly, resulting in a $133.3 billion worsening of the budget balance by 2004. Joint changes in interest rates and inflation have a smaller effect on the deficit than equal percentage point changes in real GDP growth, because their effects on receipts and outlays are substantially offsetting. An example is the effect of a one percentage point higher rate of inflation and one percentage point higher interest rates during calendar year 1999 only. In subsequent years, the price level and nominal GDP would be one percent higher than in the base case, but interest rates are assumed to return to their base levels. Outlays for 1999 rise by $5.6 billion and receipts by $9.2 billion, for a increase of $3.6 billion in the 1999 surplus. In 2000, outlays would be above the base by $12.9 billion, due in part to lagged cost-of-living adjustments; receipts ANALYTICAL PERSPECTIVES would rise $18.4 billion above the base, however, resulting in a $5.6 billion improvement in the budget balance. In subsequent years, the amounts added to receipts would continue to be larger than the additions to outlays. If the rate of inflation and the level of interest rates are higher by one percentage point in all years, the price level and nominal GDP would rise by a cumulatively growing percentage above their base levels. In this case, the effects on receipts and outlays mount steadily in successive years, adding $54.0 billion to outlays and $109.0 billion to receipts in 2004, for a net increase in the surplus of $55.0 billion. The table shows the interest rate and the inflation effects separately. These separate effects for interest rates and inflation rates do not sum to the effects for simultaneous changes in both. This occurs because, when the budget is in surplus and some debt is being retired, the combined effects of two changes in assumptions affecting debt financing patterns and interest costs may differ from the sum of the separate effects, depending on assumptions about Treasury’s selection of debt maturities to retire and the interest rates they bear. The last entry in the table shows rules of thumb for the added interest cost associated with changes in the budget surplus. The effects of changes in economic assumptions in the opposite direction are approximately symmetric to those shown in the table. The impact of a one percentage point lower rate of inflation or higher real growth would have about the same magnitude as the effects shown in the table, but with the opposite sign. These rules of thumb are computed while holding the income share composition of GDP constant. Because different income components are subject to different taxes and tax rates, estimates of total receipts can be affected significantly by changing income shares. However, the relationships between changes in income shares and changes in growth, inflation, and interest rates are too complex to be reduced to simple rules. 1. 15 ECONOMIC ASSUMPTIONS Table 1–6. SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS (In billions of dollars) Budget effect Real Growth and Employment Budgetary effects of 1 percent lower real GDP growth: For calendar year 1999 only: 1 Receipts ................................................................................................... Outlays .................................................................................................... 1999 2000 2001 2002 2003 2004 –8.0 1.8 –17.2 6.1 –20.1 6.6 –20.9 8.0 –21.8 9.7 –22.7 11.5 Decrease in surplus (–) ...................................................................... Sustained during 1999–2004: 1 Receipts ................................................................................................... Outlays .................................................................................................... –9.8 –23.3 –26.7 –28.9 –31.5 –34.2 –8.0 1.8 –25.4 8.0 –46.1 14.7 –68.3 23.1 –92.0 33.3 –117.5 45.7 Decrease in surplus (–) ...................................................................... Sustained during 1999–2004, with no change in unemployment: Receipts ................................................................................................... Outlays .................................................................................................... –9.8 –33.4 –60.9 –91.4 –125.4 –163.3 –8.0 0.2 –25.4 1.0 –46.2 2.8 –68.4 5.7 –92.1 10.0 –117.6 15.7 Decrease in surplus (–) ...................................................................... Inflation and Interest Rates Budgetary effects of 1 percentage point higher rate of: Inflation and interest rates during calendar year 1999 only: Receipts ................................................................................................... Outlays .................................................................................................... –8.2 –26.4 –49.0 –74.2 –102.1 –133.3 9.2 5.6 18.4 12.9 17.8 10.3 16.4 9.2 17.2 9.0 18.1 8.3 Increase in surplus (+) ....................................................................... Inflation and interest rates, sustained during 1999–2004: Receipts ................................................................................................... Outlays .................................................................................................... 3.6 5.6 7.5 7.2 8.2 9.7 9.2 5.6 28.1 18.6 47.1 29.3 65.7 38.1 86.3 46.4 109.0 54.0 Increase in surplus (+) ....................................................................... Interest rates only, sustained during 1999–2004: Receipts ................................................................................................... Outlays .................................................................................................... 3.6 9.5 17.8 27.6 39.9 55.0 1.3 5.2 3.3 14.1 4.1 18.5 4.4 20.3 4.8 21.6 5.1 22.2 Decrease in surplus (–) ...................................................................... Inflation only, sustained during 1999–2004: Receipts ................................................................................................... Outlays .................................................................................................... –3.9 –10.9 –14.4 –15.9 –16.9 –17.1 8.0 0.5 24.8 4.7 43.0 11.3 61.3 18.7 81.6 26.4 103.9 34.1 Increase in surplus (+) ....................................................................... Interest Cost of Higher Federal Borrowing Outlay effect of a $50 billion reduction in the 1999 surplus ......................... 7.5 20.2 31.7 42.6 55.2 69.7 1.2 2.4 2.5 2.7 2.9 3.0 * $50 million or less. 1 The unemployment rate is assumed to be 0.5 percentage point higher per 1.0 percent shortfall in the level of real GDP. 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET Introduction A full evaluation of the Government’s financial condition must consider a broader range of data than would usually be shown on a business balance sheet. A balanced assessment of the Government’s financial condition requires several complementary perspectives. This chapter presents a framework for such analysis. No single table in this chapter is ‘‘the balance sheet’’ of the Federal Government. Rather, the chapter taken as a whole provides an overview of the Government’s financial resources, the current and future claims on them, and what the taxpayer gets in exchange for these resources. This is the kind of assessment for which a financial analyst would turn to a business balance sheet, but this chapter is expanded to take into account the Government’s unique roles and circumstances. Because of the differences between Government and business, and because there are serious limitations in the available data, this chapter’s findings should be interpreted with caution. The conclusions are tentative and subject to revision. The presentation consists of three parts: • The first part reports on what the Federal Government owns and what it owes. Table 2–1 summarizes this information. The assets and liabilities in this table are a useful starting point for analysis, but they are only a partial reflection of the full range of Government resources and responsibilities. Only those items actually owned by the Government are included in the table, but its resources extend beyond the assets defined in this narrow way. Government can also rely on taxes and other measures to meet future obligations. Similarly, while the table’s liabilities include all of the binding commitments resulting from prior Government action, Government’s responsibilities are much broader than this. • The second part presents possible paths for the Federal budget extending well into the next century, beginning with an extension of the 2000 Budget. Table 2–2 summarizes this information. This part offers the clearest indication of the longrun financial demands that the Government faces and the resources that will be available to meet them. Some future claims on the Government deserve special emphasis because of their importance to individuals’ retirement plans. Table 2–3 summarizes the condition of the Social Security and Medicare trust funds and how that condition has changed since 1997. • The third part of the presentation features information on economic and social conditions which the Government affects by its actions. Table 2–4 presents summary data for national wealth while highlighting the Federal investments that have contributed to that wealth. Table 2–5 presents a small sample of economic and social indicators. Relationship with FASAB Objectives The framework presented here meets the stewardship objective 1 for Federal financial reporting recommended by the Federal Accounting Standards Advisory Board and adopted for use by the Federal Government in September 1993. Federal financial reporting should assist report users in assessing the impact on the country of the Government’s operations and investments for the period and how, as a result, the Government’s and the Nation’s financial conditions have changed and may change in the future. Federal financial reporting should provide information that helps the reader to determine: 3a. Whether the Government’s financial position improved or deteriorated over the period. 3b. Whether future budgetary resources will likely be sufficient to sustain public services and to meet obligations as they come due. 3c. Whether Government operations have contributed to the Nation’s current and future well-being. The presentation here explores an experimental approach for meeting this objective at the Governmentwide level. What Can Be Learned from a Balance Sheet Approach The budget is an essential tool for allocating resources within the Federal Government and between the public and private sectors; but the standard budget presentation, with its focus on annual outlays, receipts, and the surplus/deficit, does not provide all the information needed for a full analysis of the Government’s financial and investment decisions. A business may ultimately be judged by the bottom line in its balance sheet, but for the National Government, the ultimate test is how its actions affect the country. 1 Objectives of Federal Financial Reporting, Statement of Federal Financial Accounting Concepts Number 1, September 2, 1993. The other objectives relate to budgetary integrity, operating performance, and systems and controls. 17 18 ANALYTICAL PERSPECTIVES QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’ 1. According to Table 2–1, the Government’s liabilities exceed its assets. No business could operate in such a fashion. Why does the Government not manage its finances more like a business? Because the Federal Government is not a business. It has fundamentally different objectives, and so must operate in different ways. The primary goal of every business is to earn a profit. But in our free market system, the Federal Government leaves almost all activities at which a profit could be earned to the private sector. In fact, the vast bulk of the Federal Government’s operations are such that it would be difficult or impossible to charge prices for them—let alone prices that would cover expenses. The Government undertakes these activities not to improve its own balance sheet, but to benefit the Nation—to foster not only monetary but also nonmonetary values. No business would—or should—sacrifice its own balance sheet to bolster that of the rest of the country. To illustrate, one of the Federal Government’s most valuable assets is its holdings of gold. The price of gold generally fluctuates counter to the state of the economy—if inflation is rapid and out of control, the price of gold rises; but when inflation slows and steadies, the price of gold falls. One source of the deterioration of the Federal Government’s balance sheet since the early 1980s has been a decline in the relative price of gold, which has reduced the real value of the Government’s gold holdings. But that price decline—and the resulting deterioration of the Government’s balance sheet—began as a direct consequence of Federal policies to reduce inflation, for the benefit of the people and businesses of the United States. No business would undertake such a policy of worsening its own balance sheet. Similarly, the Federal Government invests in education and research. The Government earns no direct return from these investments; but the Nation and its people are made richer. A business’s motives for investment are quite different; business invests to earn a profit for itself, not others. Because the Federal Government’s objectives are different, its balance sheet behaves differently, and should be interpreted differently. 2. But Table 2–1 seems to imply that the Government is insolvent. Is it? No. Just as the Federal Government’s responsibilities are of a different nature than those of a private business, so are its resources. Government solvency must be evaluated in different terms. What the table shows is that those Federal obligations that are most comparable to the liabilities of a business corporation exceed the estimated value of the assets the Federal Government actually owns. However, the Government has access to other resources through its sovereign powers, which include taxation. These powers give the Government the ability to meet present obligations and those that are anticipated from future operations. The financial markets clearly recognize this reality. The Federal Government’s implicit credit rating is the best in the United States; lenders are willing to lend it money at interest rates substantially below those charged to private borrowers. This would not be true if the Government were really insolvent or likely to become so. In countries where governments totter on the brink of insolvency, lenders are either unwilling to lend them money, or do so only in return for a substantial interest premium. However, the Federal Government’s balance sheet was clearly worsened by the budget policies of the 1980s. Under President Clinton, the deterioration in the balance sheet has been halted, and as the budget has moved from deficit to surplus, the excess of Government liabilities over assets has leveled off and begun to shrink relative to the size of the economy. 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’—Continued 3. The Government does not comply with the accounting requirements imposed on private businesses. Why does the government not keep a proper set of books? Because the Government is not a business, and its primary goal is not to earn profits or to enhance its own wealth. Accounting standards designed to illuminate how much a business earns and how much equity it has would not provide useful information if applied to the Government, and might even be misleading. In recent years, the Federal Accounting Standards Advisory Board has developed, and the Federal Government has adopted, a conceptual accounting framework that reflects the Government’s functions and answers the questions for which Government should be accountable. This framework addresses budgetary integrity, operating performance, stewardship, and systems and controls. The Board has also developed, and the Government has adopted, a full set of accounting standards. Federal agencies are issuing audited financial reports that follow these standards; an audited Government-wide consolidated financial report was issued last year. This chapter addresses the ‘‘stewardship objective’’—assessing the interrelated condition of the Federal Government and of the Nation. The data in this chapter are intended to illuminate the trade-offs and connections between making the Federal Government ‘‘better off’’ and making the Nation ‘‘better off.’’ There is no ‘‘bottom line’’ for the Government comparable to the net worth of a business corporation. Some analysts may find the absence of a bottom line to be frustrating. But pretending that there is such a number—when there clearly is not—does not advance the understanding of Government finances. 4. Why is Social Security not shown as a liability in Table 2–1? Formally, construing Social Security as a liability would entail several conceptual contradictions. There are other Federal programs that are very similar to Social Security in the promises they make—Medicare, Medicaid, Veterans pensions, and Food Stamps, to name a few. Should the future benefits expected from these programs also be treated as liabilities? It would be difficult to justify a different accounting treatment for them if Social Security were classified as a liability of the Government. There is no bright dividing line separating Social Security from other income-maintenance programs. Furthermore, if future Social Security benefits were to be treated as liabilities, logic would suggest that future Social Security payroll tax receipts that are earmarked to finance those benefits ought to be considered assets. However, other tax receipts are not counted as assets; and drawing a line between Social Security taxes and other taxes would be questionable. 19 20 ANALYTICAL PERSPECTIVES QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’—Continued 5. It is all very well to run a budget surplus now, but can this be sustained? When the babyboom generation retires beginning in 2008, will the deficit not return larger and meaner than ever before? The aging of the U.S. population, which will become dramatically evident when the babyboomers retire, poses serious long-term problems for the Federal budget and its major entitlement programs. However, the surplus in the budget means the country is better prepared to address these problems. If current projections prove correct and the surplus is preserved for some time to come, then there will be a significant decline in Federal net interest payments because of the decline in Federal debt resulting from the surpluses. This is a key step towards keeping the budget in balance when the baby-boomers retire. The second part of this chapter and the charts that accompany it show how the budget is likely to fare under various possible alternative scenarios. 6. Would it be sensible for the Government to borrow to finance needed capital—permitting a deficit in the budget—so long as it was no larger than the amount spent on Federal investments? First of all, the Government consumes capital each year in the process of providing goods and services to the public. The rationale for using Federal borrowing to finance investment really only applies to net investment, after depreciation is subtracted, because only net investment augments the Government’s assets and offsets the increase in liabilities that result from borrowing. If the Government financed all new capital by borrowing, it should pay off the debt as the capital acquired in this way loses value. As discussed in Chapter 6 of Analytical Perspectives, net investment in physical capital owned by the Federal Government is estimated to have been negative in 1998 and to remain negative in 1999 and 2000, so no deficit spending would actually be justified by this borrowing-for-investment criterion. The Federal Government also funds substantial amounts of physical capital that it does not own, such as highways and research facilities, and it funds investment in intangible ‘‘capital’’ such as education and training and the conduct of research and development. A private business would never borrow to spend on assets that would be owned by someone else. However, such spending is a principal function of Government. Chapter 6 shows that when these investments are also included, net investment is estimated to be slightly positive in 1999 and 2000. It is not clear whether this type of capital investment would satisfy the borrowing-for-investment criterion. Certainly, these investments do not create Federally owned assets, even though they are part of national wealth. There is another hitch in the logic of borrowing to invest. Businesses expect investments to earn a profit from which to repay the financing costs. In contrast, the Federal Government does not generally expect to receive a direct payoff (in the form of higher tax receipts) from its investments, whether or not it owns them. In this sense, Government investments are no different from other Government expenditures, and the fact that they provide services over a longer period is no justification for excluding them when calculating the surplus/deficit. Finally, the Federal Government must pursue policies that support the overall financial and economic well-being of the Nation. In this broader context, the Government may need to manage its fiscal policy to run a surplus, so as to augment private saving and investment, even if this means paying for its own investments from current revenues, instead of borrowing in the credit market and crowding out private investment. Other considerations than the size of Federal investment need to be weighed in choosing the appropriate level of the surplus or deficit. 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’—Continued 7. Is it misleading to include the Social Security surplus when measuring the Government’s budget surplus? For many years, experts have said that the Federal budget has three purposes: to plan the Government’s fiscal program; to impose financial discipline on the Government’s activities; and to measure the Government’s effect on the economy. It should not be surprising that, with more than one purpose, the budget is routinely presented in more than one way. For years, there have been several alternative measures of the budget, each with its appropriate use. None of these measures is always right, or always wrong; it depends upon the purpose to which the budget is put. For the purpose of measuring the Government’s effect on the economy, it would be misleading to omit any part of the budget; doing so would simply miss part of what we were trying to measure. For example, we would need to know all of the Federal Government’s receipts and outlays to know whether it will have the wherewithal to meet its future obligations—such as Social Security. And for purposes of fiscal discipline, leaving out particular Government activities could be dangerous. In fact, the principle of a ‘‘unified,’’ all-inclusive budget was established by President Johnson’s Commission on Budget Concepts largely to forestall a trend toward moving favored programs off-budget—which had been done explicitly to shield those programs from scrutiny and funding discipline. To plan the Government’s program, however, alternative perspectives can sometimes be useful. In particular, the Congress has moved Social Security off-budget. The purpose was to stress the need to provide independent, sustainable funding of Social Security in the long term; and to show the extent to which the rest of budget had relied on annual Social Security surpluses to make up for its own shortfalls. Policy under this Administration has been consistent with these goals. The non-Social Security deficit has been virtually eliminated—falling consistently from its record $340 billion in 1992 to only $30 billion, the lowest in more than a quarter of a century, in 1998. We anticipate that the non- Social Security budget will move solidly into surplus within the time horizon of this budget. And the President has made long-term Social Security soundness a key priority for this year. In sum, the budget is like a toolbox that contains different tools to perform different functions. There is a right tool for each task, but no one tool is right for every task. If we choose the right tool for the job at hand, we can achieve our objectives. 8. What good does it do for the Federal Government to run a budget surplus, if the surplus is only used to retire Government debt? Is this just another way of pouring the money down the drain? When the Government retires its debt, it is not pouring money down the drain. The Government contributes to the accumulation of national wealth by using a budget surplus to repay Government debt. Because of the large budget deficits of the 1980s, Federal debt measured relative to the size of the economy has risen to levels not seen since the early 1960s. Reducing this accumulated debt will have several desirable economic effects. It will help to hold down real interest rates, which is good for investment and home ownership. Lowering the debt will give the Government more flexibility should it face an unexpected need to borrow in the future. When the Government uses a budget surplus to reduce its debt, it adds to national saving. Even though the Government is simply repaying its debt, the resources represented by the surplus are available for private investment in new plant and equipment, new homes, and other durable assets. 21 22 The data needed to judge its performance go beyond a simple measure of net assets. Consider, for example, Federal investments in education or infrastructure whose returns flow mainly to the private sector and which are often owned by households, private businesses or other levels of government. From the standpoint of the Federal Government’s ‘‘bottom line,’’ these investments might appear to be unnecessary or even wasteful; but they make a real contribution to the economy and to people’s lives. A framework for evaluating Federal finances needs to take Federal investments into account, even when the return they earn accrues to someone other than the Federal Government. A good starting point to evaluate the Government’s finances is to examine its assets and liabilities. An illustrative tabulation of net assets is presented below in Table 2–1, based on data from a variety of public and private sources. It has sometimes been suggested that the Federal Government’s assets, if fully accounted for, would exceed its debts. Table 2–1 clearly shows that this is not correct. The Federal Government’s assets are less than its debts; the deficits in the 1980s caused Government debts to increase far more than Government assets. But that is not the end of the story. The Federal Government has resources that go beyond the assets that normally appear on a conventional balance sheet, including the Government’s sovereign powers to tax, regulate commerce, and set monetary policy. However, these powers call for special treatment in financial analysis. The best way to incorporate them is to make a long-run projection of the Federal budget (as is done in the second part of this chapter). The budget provides a comprehensive measure of the Government’s annual cash flows. Projecting it forward shows how the Government’s sovereign powers are expected to generate cash flows in the future. On the other side of the ledger are the Government’s binding obligations such as Treasury debt, and the present discounted value of Federal obligations to pay pension benefits to Government retirees and current employees when they retire. These obligations have counterparts in the business world, and would appear on a business balance sheet. Accrued obligations for government insurance policies and the estimated present value of failed loan guarantees and deposit insurance claims are also analogous to private liabilities, and are included with the other Government liabilities. ANALYTICAL PERSPECTIVES These formal obligations, however, form only a subset of the Government’s financial responsibilities. The Government has established a broad range of programs that dispense cash and other benefits to individual recipients. The Government is not constitutionally obligated to continue payments under these programs; the benefits can be modified or even ended at any time, subject to the decisions of the elected representatives in Congress. Such changes are a regular part of the legislative cycle. Allowing for such changes, however, it is likely that many of these programs will remain Federal obligations in some form for the foreseeable future. Again, the best way to see how future responsibilities line up with future resources is to project the Federal budget forward far enough in time to capture the long-run effects of current and past decisions. Projections of this sort are presented below. The budget, even when projected far into the future, does not show whether the public is receiving value for its tax dollars. Information on that point requires performance measures for government programs supplemented by appropriate information about conditions in the U.S. economy and society. Such data are currently available, but much more need to be developed to obtain a full picture. Examples of what might be done are also shown below. (Performance measures are discussed more fully in Section VI of this year’s Budget.) The presentation that follows consists of a series of tables and charts. All of them taken together function as a Federal balance sheet. The schematic diagram, Chart 2.1, shows how they fit together. The tables and charts should be viewed as an ensemble, the main elements of which can be grouped together in two broad categories—assets/resources and liabilities/responsibilities. • Reading down the left-hand side of the diagram shows the range of Federal resources, including assets the Government owns, tax receipts it can expect to collect, and national wealth that provides the base for Government revenues. • Reading down the right-hand side reveals the full range of Federal obligations and responsibilities, beginning with Government’s acknowledged liabilities based on past actions, such as the debt held by the public, and going on to include future budget outlays. This column ends with a set of indicators highlighting areas where Government activity affects society or the economy. 23 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET Chart 2-1. A BALANCE SHEET PRESENTATION FOR THE FEDERAL GOVERNMENT ASSETS/RESOURCES LIABILITIES/RESPONSIBILITIES Federal Assets Federal Liabilities Financial Assets Gold and Foreign Exchange Other Monetary Assets Mortgages and Other Loans Less Expected Loan Losses Other Financial Assets Financial Liabilities Currency and Bank Reserves Debt Held by the Public Miscellaneous Guarantees and Insurance Deposit Insurance Pension Benefit Guarantees Loan Guarantees Other Insurance Federal Pension Liabilities Physical Assets Fixed Reproducible Capital Defense Nondefense Inventories Non-reproducible Capital Land Mineral Rights Resources/Receipts Projected Receipts Federal Governmental Assets and Liabilities (Table 2-1) Net Balance Long-Run Federal Budget Projections (Table 2-2) Change in Trust Fund Balances (Table 2-3) National Assets/Resources Federally Owned Physical Assets State & Local Physical Assets Federal Contribution Privately Owned Physical Assets Education Capital Federal Contribution R&D Capital Federal Contribution National Wealth (Table 2-4) Social Indicators (Table 2-5) Responsibilities/Outlays Discretionary Outlays Mandatory Outlays Social Security Health Programs Other Programs Net Interest Deficit National Needs/Conditions Indicators of economic, social, educational, and environmental conditions to be used as a guide to Government investment and management. 24 ANALYTICAL PERSPECTIVES PART I—THE FEDERAL GOVERNMENT’S ASSETS AND LIABILITIES Table 2–1 summarizes what the Government owes as a result of its past operations along with the value of what it owns, for a number of years beginning in 1960. The values of assets and liabilities are measured in terms of constant FY 1998 dollars. For most of this period, Government liabilities have exceeded the value of assets, but until the early 1980s the disparity was relatively small, and it was growing slowly (see chart 2–2). In the late 1970s, a speculative run-up in the prices of oil, gold, and other real assets temporarily boosted the value of Federal holdings, but since then those prices have declined.2 Currently, the total real value of Federal assets is estimated to be only about 12 percent greater than it was in 1960. Meanwhile, Federal liabilities have increased by 167 percent in real terms. The sharp decline in the Federal net asset position was principally due to large Federal budget deficits along with a drop in certain asset values. Currently, the net excess of liabilities over assets is about $3.2 trillion, or $12,000 per capita. Assets The assets in Table 2–1 are a comprehensive list of the financial and physical resources owned by the Federal Government. The list corresponds to items that would appear on a typical balance sheet. Financial Assets: According to the Federal Reserve Board’s Flow-of-Funds accounts, the Federal Government’s holdings of financial assets amounted to about $0.2 trillion at the end of FY 1998. Government-held mortgages and other loans (measured in constant dollars) reached a peak in the mid-1980s. Since then, the value of Federal loans has declined. The holdings of mortgages, in particular, have declined sharply as holdings acquired from failed savings and loan institutions have been liquidated. The face value of mortgages and other loans overstates their economic worth. OMB estimates that the discounted present value of future losses and interest subsidies on these loans is $45 billion as of 1998. These estimated losses are subtracted from the face value of outstanding loans to obtain a better estimate of their economic worth. Over time, variations in the price of gold have accounted for major swings in this category. Since the end of FY 1980, gold prices have fallen and the real value of U.S. gold and foreign exchange holdings has dropped by 58 percent. Reproducible Capital: The Federal Government is a major investor in physical capital. Government-owned stocks of fixed capital amounted to about $1.0 trillion 2 This temportary improvement highlights the importance of the othr tables in this presentation. What is good for the Federal Government as an asset holder is not necessary favorable to the economy. The decline in inflation in the early 1980s reversed the speculative runnup in gold and other commodity prices. This reduced the balance of Federal net assets, but it was good for the economy and the nation as a whole. in 1998 (OMB estimate). About two-thirds of this capital took the form of defense equipment or structures. Non-reproducible Capital: The Government owns significant amounts of land and mineral deposits. There are no official estimates of the market value of these holdings (and of course, in a realistic sense, much of this land could or would never be sold). Researchers in the private sector have estimated what they are worth, and these estimates are extrapolated in Table 2–1. Private land values fell sharply in the early 1990s, although they have risen somewhat since 1993. It is assumed here that federal land shared in the decline and the subsequent recovery. Oil prices have declined sharply in recent years and are now lower in nominal terms than at any time since the late 1980s, reducing the value of Federal mineral deposits. (The estimates omit other types of valuable assets owned by the Government, such as works of art or historical artefacts, simply because the valuation of such assets would have little realistic basis in fact, and because most of these objects would never be sold.) Total Assets: The total real value of Government assets is lower now than at the end of the 1980s, principally because of declines in the real value of gold, land, and minerals. Even so, the Government’s holdings are vast. At the end of 1998, the value of Government assets is estimated to have been about $2.3 trillion. Liabilities Table 2–1 includes only those liabilities that would appear on a business balance sheet. These include various forms of Federal debt, Federal pension obligations to civilian and military employees, and liabilities for Federal insurance and loan guarantee programs. Financial Liabilities: Financial liabilities amounted to about $3.9 trillion at the end of 1998. The largest component was Federal debt held by the public, amounting to around $3.3 trillion. This measure of Federal debt is net of the holdings of the Federal Reserve System (about $0.4 trillion at the end of FY 1998). Although independent in its policy deliberations, the Federal Reserve is part of the Federal Government, and its assets and liabilities are included here in the Federal totals. In addition to debt held by the public, the Government’s financial liabilities include approximately $0.5 trillion in currency and bank reserves, which are mainly obligations of the Federal Reserve System, and about $0.1 trillion in miscellaneous liabilities. Guarantees and Insurance Liabilities: The Federal Government has contingent liabilities arising from loan guarantees and insurance programs. When the Government guarantees a loan or offers insurance, cash disbursements may initially be small or, if a fee is charged, the Government may even collect money; but the risk of future cash payments associated with such commitments can be very large. The figures reported in Table 2–1 are prospective estimates showing the current discounted value of expected future losses. The GOVERNMENT ASSETS AND LIABILITIES * (As of the end of the fiscal year, in billions of 1998 dollars) 1960 1965 1970 1975 1980 1985 1990 1991 1992 1993 1994 1995 1996 1997 1998 ASSETS Financial Assets: Gold and Foreign Exchange ................................... Other Monetary Assets ............................................ Mortgages and Other Loans ................................... less Expected Loan and Losses ........................ Other Financial Assets ............................................ 103 39 127 –1 61 72 55 163 –3 81 61 33 211 –4 65 136 15 211 –9 66 336 39 290 –17 82 161 25 356 –17 106 202 32 289 –19 159 181 23 293 –21 190 178 41 270 –23 222 178 41 240 –25 201 178 32 225 –27 188 185 32 213 –23 186 170 44 202 –23 187 142 45 200 –41 185 140 46 211 –45 179 Subtotal ................................................................ Physical Assets: Fixed Reproducible Capital: Defense ................................................................ Nondefense .......................................................... Inventories ................................................................ Nonreproducible Capital:. Land ..................................................................... Mineral Rights ...................................................... 329 370 365 419 731 631 663 665 688 636 596 592 580 530 531 932 138 264 911 212 228 887 249 212 724 273 189 628 296 230 789 319 263 818 337 229 831 340 208 828 342 202 815 343 186 803 346 177 779 351 158 754 352 141 712 345 130 695 348 121 91 329 126 304 157 250 243 348 309 632 332 712 328 476 299 451 267 425 251 404 247 374 248 351 251 398 261 418 277 351 Subtotal ........................................................... 1,753 1,782 1,755 1,776 2,095 2,415 2,188 2,129 2,065 2,000 1,948 1,887 1,895 1,867 1,792 Total Assets .............................................. 2,082 2,152 2,120 2,196 2,826 3,047 2,851 2,795 2,753 2,636 2,544 2,479 2,475 2,397 2,323 230 999 26 253 986 28 279 836 30 284 822 43 285 1,063 67 302 1,887 93 360 2,590 139 365 2,793 127 383 3,050 119 413 3,201 118 439 3,287 115 447 3,381 111 458 3,438 112 478 3,390 105 514 3,274 106 Subtotal ................................................................ Insurance Liabilities: Deposit Insurance .................................................... Pension Benefit Guarantee 1 ................................... Loan Guarantees ..................................................... Other Insurance ....................................................... 1,254 1,265 1,145 1,149 1,415 2,283 3,089 3,286 3,552 3,732 3,840 3,940 4,008 3,974 3,894 0 0 0 31 0 0 0 28 0 0 2 22 0 43 6 20 2 31 12 27 9 43 10 17 69 42 15 19 76 46 24 19 39 51 27 19 13 66 30 18 9 32 32 17 5 20 28 17 2 54 32 16 1 30 30 16 1 40 22 16 Subtotal ................................................................ Federal Pension Liabilities ........................................... 31 794 29 1,006 24 1,194 70 1,355 72 1,781 79 1,766 146 1,694 165 1,683 135 1,694 127 1,629 90 1,603 69 1,619 105 1,579 77 1,588 78 1,587 Total Liabilities ........................................................... Balance ........................................................................ 2,080 2 3,301 –149 2,363 –243 2,574 –378 3,269 –443 4,127 –1,080 4,929 –2,077 5,133 –2,339 5,381 –2,629 5,488 –2,851 5,534 –2,989 5,628 –3,149 5,691 –3,216 5,640 –3,243 5,559 –3,235 12 0.1 –766 –4.6 –1,184 –6.3 –1,752 –8.7 –1,938 –8.5 –4,519 –17.8 –8,288 –30.1 –9,231 –33.9 –10,262 –37.0 –11,016 –39.2 –11,438 –39.7 –11,936 –41.0 –12,081 –40.3 –12,077 –39.1 –11,947 –37.7 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET Table 2–1. LIABILITIES Financial Liabilities: Currency and Bank Reserves ................................. Debt held by the Public ........................................... Miscellaneous ........................................................... Addenda: Balance Per Capita (in 1998 dollars) ....................... Ratio to GDP (in percent) ......................................... * This table shows assets and liabilites for the Government as a whole, including the Federal Reserve System. Therefore, it does not break out separately the assets held in Government accounts, such as Social Security, that are the obligation of specific Government agencies. Estimates for FY 1998 are extrapolated in some cases. 1 The model and data used to calculate this liability were revised for 1996–1997. 25 26 ANALYTICAL PERSPECTIVES Chart 2-2. NET FEDERAL LIABILITIES PERCENT OF GDP 50 40 30 20 10 0 -10 1960 1964 1968 1972 1976 present value of all such losses taken together is about $0.1 trillion. The resolution of the many failures in the savings and loan and banking industries has helped to reduce the liabilities in this category by more than half since 1990. Federal Pension Liabilities: The Federal Government owes pension benefits to its retired workers and to current employees who will eventually retire. The amount of these liabilities is large. The discounted present value of the benefits is estimated to have been around $1.6 trillion at the end of FY 1998.3 1980 1984 1988 1992 1996 The Balance of Net Liabilities Because of its sovereign powers, the Government need not maintain a positive balance of net assets, and the rapid buildup in liabilities since 1980 has not damaged Federal creditworthiness. However, from 1980 to 1992, the balance between Federal liabilities and Federal assets did deteriorate at a very rapid rate. In 1980, the negative balance was less than 10 percent of GDP; by 1995 it was 41 percent of GDP. Since then, the net balance as a percentage of GDP has improved for three straight years. If a budget surplus is maintained, the net balance will continue to improve. PART II—THE BALANCE OF RESOURCES AND RESPONSIBILITIES As noted in the preceding section, a business-type accounting of assets and liabilities misses the role of the Government’s unique sovereign powers, including taxation. Therefore, the best way to examine the balance between future Government obligations and resources is by projecting the budget over the long run. The budget offers a comprehensive measure of the Government’s annual financial burdens and resources. By projecting annual receipts and outlays, it is possible to examine whether there will be sufficient resources to support all of the Government’s ongoing obligations. 3 These pension liabilities are expressed as the actuarial present value of benefits accruedto-date based on past and projected salaries. The cost of retiree health benefits is not included. The 1998 liability is extrapolated from recent trends. This part of the presentation describes long-run projections of the Federal budget extending beyond the normal budget horizon. Forecasting the economy and the budget over such a long period is highly uncertain. Future budget outcomes depend on a host of unknowns—constantly changing economic conditions, unforeseen international developments, unexpected demographic shifts, the unpredictable forces of technological advance, and evolving political preferences. Those uncertainties increase the further into the future the projections are pushed. Even so, long-run budget projections are needed to assess the full implications of cur- 27 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET rent action or inaction, and to sound warnings about future problems that could be avoided by timely action. The Federal Government’s responsibilities extend well beyond the next decade. There is no time limit on Government’s constitutional responsibilities, and programs like Social Security are intended to continue indefinitely. It is evident even now that there will be mounting challenges to the budget early in the next century. By 2008, the first of the huge baby-boom generation born after World War II will become eligible for early retirement under Social Security. In the years that follow there will be serious strains on the budget because of increased expenditures for Social Security, Medicare, and Medicaid. Long-range projections can help indicate how serious these strains might become and what is needed to withstand them. The retirement of the baby-boomers dictates the timing of the problem, but the underlying cause is deeper. The growth of the U.S. population has been slowing down, and because of that and because people are living longer, a change is inevitably coming in the ratio of retirees to workers given current retirement patterns. The budgetary pressure from these trends is temporarily in abeyance. In the 1990s, the large baby-boom cohort has been moving into its prime earning years, while the retirement of the much smaller cohort born during the Great Depression has been holding down the rate of growth in the retired population. The suppressed budgetary pressures are likely to burst forth when the baby-boomers begin to retire. However, even after the baby-boomers have passed from the scene later in the century, a higher ratio of retirees to workers is expected to persist because of the underlying pattern of low fertility and improving longevity, with concomitant problems for the retirement programs. These same problems are gripping other developed nations, even those that never experienced a baby-boom; in fact, those nations that did not have baby-booms are facing their demographic pressures already. The Improvement in the Long-Range Outlook.— Since this Administration first took office, there have been major changes in the long-run budget outlook. In January 1993, the deficit was clearly on an unstable trajectory. Had the policies then in place continued unchanged, the deficit would have steadily mounted not only in dollar terms, but relative to the size of the economy.4 At that time, the deficit was projected to rise to over 10 percent of GDP by 2010—a level unprecedented for peacetime—and to continue sharply upward thereafter. This would have driven Federal debt held by the public to unsustainable levels. The Omnibus Budget Reconciliation Act of 1993 (OBRA) changed that. Not only did it reduce the nearterm deficit, but, aided by the strong economy that 4 Over long periods when the rate of inflation is positive, comparisons of dollar values are meaningless. Even the low rate of inflation assumed in this budget will reduce the value of a 1998 dollar by 50 percent by 2030, and by almost 70 percent by the year 2050. For long-run comparisons, it is much more useful to examine the ratio of the deficit and other budget categories to the expected size of the economy as measured by GDP. it helped to create, it also reduced the long-term deficit. Prior to enactment of the Balanced Budget Agreement in 1997, however, the deficit was expected to persist, though at a more moderate level. In the absence of further policy changes, it was projected to remain at around 1.5 percent of GDP through 2010, and afterwards to begin an unsustainable rise that would eventually exceed 20 percent of GDP. The Balanced Budget Agreement (BBA) took the next major step. With the strength of the economy over the last three years, the budget reached balance ahead of schedule; and thanks to the BBA, it is now projected to remain in surplus throughout the next decade. Extending the policies in this budget beyond the usual budget window, a surplus may be sustained for many years, although a deficit is projected to reemerge in the long run absent further policy changes. How long the surplus can be preserved depends on certain key factors, some of the most important of which are illustrated in Chart 2–3. Fiscal discipline is crucial for long-run budget stability. The rate of growth in discretionary spending helps determine the margin of resources available to devote to other purposes, such as debt reduction. Chart 2–3 illustrates how the surplus varies depending on assumptions about future growth in discretionary spending. Another key factor is the expected growth of Federal health care costs. The usual forecasting convention in past budgets was to adopt the long-range projections of the Medicare actuaries. Those projections include a slowdown in the rate of growth in real per capita spending under Medicare beginning in about 15 years. More rapid growth of Medicare, closer to the historical trend for the program, would result in a faster return to deficits, as shown in Chart 2–3. Under most reasonable alternatives, the long-run budget outlook contrasts favorably with the generally prevailing opinion among budget experts just a few years back. Then, it was held that the long-run outlook for the deficit was necessarily bleak. For some time, there has been a general consensus among demographers and economists that population trends in the next century will put strains on the budget, and it was thought that these strains must inevitably lead to large deficits. For example, the 1994 report of the Bipartisan Commission on Entitlement and Tax Reform found that there is a ‘‘long-term imbalance between the government’s entitlement promises and the funds it will have available to pay for them.’’ The Congressional Budget Office (CBO) has observed: ‘‘If the budgetary pressure from both demography and health care spending is not relieved by reducing the growth of expenditures or increasing taxes, deficits will mount and seriously erode future economic growth.’’5 On a narrower front, the annual Trustees’ reports for both Social Security and Medicare have for some time projected long-run actuarial deficiencies. One sign that the consensus may have shifted somewhat as a result of recent policy actions is provided 5 Long-Term Budgetary Pressures and Policy Options, March 1997. 28 ANALYTICAL PERSPECTIVES by the most recent of a series of reports from the General Accounting Office (GAO) on the long-run budget outlook.6 GAO observes that, ‘‘Major progress has been made on deficit reduction ... While our 1995 simulations showed deficits exceeding 20 percent of GDP by 2024 ..., our updated model results show that this point would not be reached until nearly 2050.’’ GAO continues to find that unsustainable deficits emerge in the long run absent major entitlement reforms, but the date at which the deficit starts to rise has been postponed significantly as a result of recent actions. Another sign is provided by CBO’s projection last August of how the surplus would evolve under the policies in place at that time. CBO foresaw a rising budget surplus through 2008, reaching almost 2 percent of GDP.7 CBO’s long-range projections envisioned continued surpluses that would bring debt held by the public close to zero by around 2020. Beyond that point, however, CBO projected a return of the deficit which would eventually drive up the level of Federal debt to unsustainable levels. The summary measure that CBO has used to indicate the magnitude of the long-run fiscal imbalance—the permanent change in taxes needed to stabilize the ratio of debt to GDP—declined to 1.2 percent of GDP from 5.4 percent of GDP in its original long-range projections from May 1996. 6 7 Analysis of Long-Term Fiscal Outlook, October 1997. The Economic and Budget Outlook: An Update, August 1998. The main reason for this improvement in the outlook has been the unexpected increase in the near-term budget surplus. Using the surpluses to retire Federal debt, as was done in 1998, will dramatically reduce debt held by the public and Federal net interest payments. Last year, net interest amounted to almost 3 percent of GDP. Under current estimates that would be cut to under 1 percent of GDP in 2009, assuming future surpluses are actually realized. This means that when the demographic pressures on Social Security and the Federal health programs begin to mount after 2008, there will be more budgetary resources available to meet the problem, and that postpones the date on which the deficit in the unified budget returns. Economic and Demographic Assumptions.—Longrun budget projections require a long-run demographic and economic forecast even though any such forecast is highly uncertain and is likely to be at least partly wrong. The forecast used here extends the Administration’s medium-term economic projections described in the first chapter of this volume, augmented by the longrun demographic projections from the most recent Social Security Trustees’ Report. • Inflation, unemployment and interest rates are assumed to hold stable at their values in the last year of the Administration budget projections, 2009: 2.3 percent per year for CPI inflation, 5.3 Chart 2-3. LONG RUN DEFICIT PROJECTIONS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 10 CURRENT SERVICES 5 0 DISCRETIONARY GROWS WITH POPULATION -5 -10 CONTINUED RAPID MEDICARE GROWTH -15 PRE-OBRA BASELINE -20 -25 -30 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET percent for the unemployment rate, and 5.4 percent for the yield on 10-year Treasury notes. • Productivity growth is assumed to continue at the same constant rate as it averages in the Administration’s medium-term projections: 1.3 percent per year. • In line with the most recent projections of the Social Security Trustees, population growth is expected to slow over the next several decades. This is consistent with recent trends in the birth rate. The slowdown is expected to lower the rate of population growth from over 1 percent per year in the early 1990s to about half that rate by 2025. • Labor force participation is also expected to decline as the population ages and the proportion of retirees in the population increases. The Administration projects a higher rate of labor force participation over the next decade than is assumed in the latest Trustees’ Report. That difference is preserved in the long-run projections below. • The projected rate of economic growth is determined in the long run by growth of the labor force plus productivity growth. Because labor force growth is expected to slow and productivity growth is assumed to be constant, real GDP growth is expected to decline from around 2.4 percent per year to an average rate of 1.5 percent per year after 2020. This is a logical implication of the other assumptions which are based on reasonable forecasting conventions; however, it implies a marked departure from the historical rate of growth in the U.S. economy. The economic projections described above are set by assumption and do not automatically change in response to changes in the budget outlook. This is unrealistic, but it simplifies comparisons of alternative policies. A more responsive (or dynamic) set of assumptions would serve mainly to strengthen the same conclusions reached by the current approach. Both CBO and GAO in their investigations of the long-run outlook have explored such feedback effects and found that they accelerate the destabilizing effects of sustained budget deficits. Similarly, but in the opposite direction, budget surpluses would be expected to lead to higher national saving, lower real interest rates, and more economic growth which would increase Federal receipts and lower outlays, further augmenting projected surpluses. Alternative Budget Baselines.—Chart 2–3 shows four alternative budget projections: one based on the policies in place prior to enactment of OBRA; and three others showing current projections, including the mandatory spending proposals in this budget under alternative assumptions about discretionary spending and future Federal health care costs. The chart illustrates the dramatic improvement in the deficit that has already been achieved. Furthermore, it shows that if the budget remains in surplus throughout the next decade, as is now expected, it will substantially ease the task of maintaining fiscal stability when the demographic bulge begins to hit after 2008. Table 2–2 shows long- 29 range projections for the major categories of spending under the three alternatives based on the current budget and shown in Chart 2–3. The table shows that for all three alternatives the entitlement programs are expected to absorb an increasing share of budget resources. • In all three alternatives, Social Security benefits, driven by the retirement of the baby-boom generation, rise from 4.5 percent of GDP in 2000 to 7.0 percent in 2030. They continue to rise after that but more gradually, eventually reaching 7.8 percent of GDP by 2075. • In all three alternatives, Federal Medicaid spending goes up from 1.3 percent of GDP in 2000 to 3.1 percent in 2030 and almost 9 percent of GDP in 2075. • Under the Medicare actuaries’ long-range projections, Medicare rises from 2.3 percent of GDP in 2000 to 4.4 percent in 2030 and 5.0 percent by 2075. If the real per capita growth rate in Medicare does not slow as much as the actuaries have assumed, the program could expand even more rapidly. In the alternative with faster spending growth, Medicare outlays reach 5.1 percent of GDP in 2030, and 9.5 percent by 2075. • Under current services assumptions, discretionary spending falls as a share of GDP, from 6.5 percent in 2000 to 4.3 percent in 2030 and 3.0 percent of GDP in 2075. The programs grow with inflation and Government wages keep pace with those paid in the private sector, but they do not keep up with population. Allowing discretionary spending to expand with both inflation and population would moderate the decline in spending as a share of GDP. Under this assumption, discretionary spending is 4.7 percent of GDP in 2030, and 3.6 percent of GDP in 2075. The long-run budget outlook is much improved because of actions taken by this Administration in cooperation with the Congress. Eliminating the budget deficit has set the budget on a solid footing for many years to come. With a continuation of the Administration’s economic assumptions, the budget could remain in surplus for several decades. However, although receipts are higher and net interest outlays are lower in these projections than they were before, the underlying demographic problems have not been eliminated, and rising health care costs are also likely to continue to put pressure on the budget. Under current services assumptions, a primary, or noninterest, deficit reappears in 2033, after the retirement of the baby-boom generation is virtually completed. Although the underlying imbalance is small, and the unified budget remains in surplus for many more years, a sustained primary deficit is sufficient to begin a slow but irreversible spiral. The recurrence of the unified deficit is inevitable once this happens unless there are future changes in policy.8 Under the alternative base8 The primary or non-interest surplus is the difference between all outlays, excluding interest, and total receipts. It can be positive even when the total budget is in deficit. 30 ANALYTICAL PERSPECTIVES Table 2–2. LONG–RUN BUDGET PROJECTIONS OF 2000 BUDGET POLICY (Percent of GDP) 1995 2000 2005 2010 2020 2030 2040 2050 2060 2070 2075 Current Services Receipts ......................................................................... Outlays ........................................................................... Discretionary .............................................................. Mandatory .................................................................. Social Security ...................................................... Medicare ............................................................... Medicaid ................................................................ Other ..................................................................... Net Interest ............................................................... Surplus(+)/Deficit(–) ....................................................... Federal debt held by the public ................................... Primary surplus/deficit (–) ............................................. 18.8 21.1 7.6 10.3 4.6 2.2 1.2 2.2 3.2 –2.3 50.1 0.9 20.7 19.4 6.5 10.5 4.5 2.3 1.3 2.5 2.4 1.3 39.2 3.7 20.0 18.0 5.6 11.0 4.5 2.5 1.5 2.5 1.4 2.0 24.0 3.5 20.1 17.1 5.1 11.5 4.7 2.7 1.7 2.4 0.5 3.1 7.0 3.6 20.6 17.6 4.6 14.0 6.0 3.5 2.4 2.1 –1.0 2.9 –21.8 1.9 20.9 19.0 4.3 16.4 7.0 4.4 3.1 1.9 –1.7 1.9 –35.2 0.2 21.2 19.6 3.9 17.5 7.2 4.7 4.0 1.7 –1.9 1.6 –38.3 –0.3 21.4 20.3 3.6 18.5 7.2 4.7 5.0 1.5 –1.9 1.1 –38.5 –0.8 21.5 22.0 3.4 20.1 7.5 4.8 6.3 1.4 –1.5 –0.5 –29.3 –2.0 21.6 24.9 3.1 22.0 7.7 5.0 7.9 1.4 –0.2 –3.3 –3.4 –3.5 21.6 26.8 3.0 23.1 7.8 5.0 8.9 1.4 0.8 –5.2 17.9 –4.4 Discretionary Grows with Population Receipts ......................................................................... Outlays ........................................................................... Discretionary .............................................................. Mandatory .................................................................. Social Security .......................................................... Medicare .................................................................... Medicaid .................................................................... Other .......................................................................... Net Interest .................................................................... Surplus(+)/Deficit(–) ........................................................... Federal debt held .............................................................. Primary surplus/deficit(–) ................................................... 18.8 21.1 7.6 10.3 4.6 2.2 1.2 2.2 3.2 –2.3 50.1 0.9 20.7 19.4 6.5 10.5 4.5 2.3 1.3 2.5 2.4 1.3 39.2 3.7 20.0 18.0 5.6 11.0 4.5 2.5 1.5 2.5 1.4 2.0 24.0 3.5 20.1 17.1 5.1 11.5 4.7 2.7 1.7 2.4 0.5 3.1 7.0 3.6 20.6 17.8 4.8 14.0 6.0 3.5 2.4 2.1 –1.0 2.8 –21.3 1.8 20.9 19.6 4.7 16.4 7.0 4.4 3.1 1.9 –1.5 1.4 –31.7 –0.1 21.2 20.5 4.4 17.5 7.2 4.7 4.0 1.7 –1.5 0.7 –29.7 –0.7 21.4 21.5 4.2 18.5 7.2 4.7 5.0 1.5 –1.2 –0.1 –23.3 –1.3 21.5 23.6 3.9 20.1 7.5 4.8 6.3 1.4 –0.4 –2.1 –6.0 –2.5 21.6 27.0 3.7 22.0 7.7 5.0 7.9 1.4 1.3 –5.4 29.3 –4.1 21.6 29.2 3.6 23.1 7.8 5.0 8.9 1.4 2.5 –7.6 55.8 –5.1 Continued Rapid Medicare Growth Receipts ......................................................................... Outlays ........................................................................... Discretionary .............................................................. Mandatory .................................................................. Social Security ...................................................... Medicare ............................................................... Medicaid ................................................................ Other ..................................................................... Net Interest ............................................................... Surplus(+)/Deficit(–) ....................................................... Federal debt held by the public ................................... Primary surplus/deficit(–) ............................................... 18.8 21.1 7.6 10.3 4.6 2.2 1.2 2.2 3.2 –2.3 50.1 0.9 20.7 19.4 6.5 10.5 4.5 2.3 1.3 2.5 2.4 1.3 39.2 3.7 20.0 18.0 5.6 11.0 4.5 2.5 1.5 2.5 1.4 2.0 24.0 3.5 20.1 17.1 5.1 11.5 4.7 2.7 1.7 2.4 0.5 3.1 7.0 3.6 20.6 17.8 4.6 14.2 6.0 3.7 2.4 2.1 –1.0 2.7 –21.2 1.7 20.9 20.0 4.3 17.2 7.0 5.1 3.1 1.9 –1.4 0.9 –29.4 –0.5 21.2 21.8 3.9 19.0 7.2 6.1 4.0 1.7 –1.0 –0.7 –19.8 –1.7 21.4 24.2 3.6 20.6 7.2 6.8 5.0 1.5 –0.1 –2.9 1.9 –2.9 21.5 28.3 3.4 23.0 7.5 7.8 6.3 1.4 1.9 –6.8 44.1 –4.9 21.6 34.3 3.1 25.9 7.7 8.9 7.9 1.4 5.3 –12.7 117.5 –7.5 21.6 38.2 3.0 27.5 7.8 9.5 8.9 1.4 7.6 –16.6 168.9 –8.9 lines shown in Chart 2–3 and Table 2–2, the primary deficit reappears even sooner. When discretionary spending grows with both population and inflation, the primary deficit reappears in 2030, and when Medicare grows more rapidly, it recurs in 2028. In all cases, a unified deficit reappears before the end of the 75 year forecast period. The Effects of Alternative Economic and Technical Assumptions. The results discussed above are highly sensitive to changes in underlying economic and technical assumptions. The three alternatives in Table 2–2 illustrate the impact of some of the key variables, but other scenarios are possible as well. There are also other policy choices that would make a large difference in the outlook. While the budget could remain under control for several decades before underlying problems reemerge, other assumptions can produce more pessimistic or more optimistic outcomes. Some of the most A relatively small primary surplus can stabilize the budget even when the total budget is in deficit, and similarly, even a small primary deficit can destabilize a budget. The mathematics are inexorable. important of these alternative economic and technical assumptions and their effects on the budget outlook are described below. Each highlights one of the key uncertainties in the outlook. Generally, the negative possibilities receive more attention than the positive ones, because the dangers are greater in this direction. 1. Discretionary Spending. By convention, the current services estimates of discretionary spending are assumed to rise with the rate of inflation. This assumption, or any other, is essentially arbitrary, because discretionary spending is always determined annually through the legislative process, and no formula can dictate future spending in the absence of legislation. The current services assumption implies that the physical quantity of Federal services is unchanging over time. This requires, for example, that the Nation’s future defense needs do not vary systematically from their current projected levels. One alternative to this assumption has already been presented in Chart 2–3 and Table 2–2. The second alternative considered there allowed discretionary spending to increase with both population and inflation after 31 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET 2014. This might be the appropriate assumption for such domestic activities as those of the FBI or the Social Security Administration which are sensitive to population trends. Some budget analysts have assumed alternatively that discretionary spending rises in proportion to GDP in the long run; this requires it to increase in real terms whenever there is positive real economic growth. That is a more generous assumption for Government spending than the assumption of constant real per capita spending. It might be argued that with rising real per capita incomes, the public demand for Government services—more national parks, better transportation, additional Federal support for scientific research— would increase as well. However, some of these demands might be met within fixed real spending limits through increased productivity in the Federal sector, such as has accompanied recent reductions of the Federal workforce. The assumption that discretionary spending will rise proportionately with GDP also flies in the face of recent experience; since its peak in 1968, the discretionary spending share of GDP has been cut in half—from 13.6 percent to 6.6 percent in 1998. Thus, there are arguments on both sides. Chart 2–4 compares the baseline alternatives with a scenario in which discretionary spending rises in step with nominal GDP after 2014. 2. Health Spending: Some of the most volatile and unpredictable elements in recent budgets have been Medicare and Medicaid. Expenditures for these programs have grown much faster than those of other enti- tlements, including Social Security. After the last year of the standard budget estimates in 2009, real per capita growth rates for Medicare benefits are based on the actuarial projections in the latest report of the Medicare Trustees, which slow down markedly in the long run. Eventually, spending for Medicare is assumed to grow at approximately the same rate as GDP. Such a slowdown may occur, and eventually, the ever-rising trend in health care costs for both Government and the private sector will have to end, but it is hard to know when and how that will happen. Improved health and increased longevity are highly valued, and society may be willing to spend even more on them than it does now. As an alternative, one of the current policy baselines allows real per capita Medicare benefits to rise at an annual rate of 2.2 percent per year in the long run. This is about twice as fast as the actuarial assumption, and implies a rapidly rising level of Medicare spending for many years to come. Eventually, Medicare would exceed 10 percent of GDP on this assumption (see Table 2–2). 3. Taxes: In the absence of policy changes, the ratio of taxes to GDP is not assumed to vary much in these long-range projections. There is a tendency for individual income taxes to rise relative to income, because the assumed rate of real income growth implies some ‘‘real bracket creep.’’ The tax code is indexed for inflation, but not for increases in real income. Eventually, a larger percentage of taxpayers will be in higher tax brackets and this will raise the ratio of taxes to income. However, other Federal taxes tend to decline in real Chart 2-4. ALTERNATIVE DISCRETIONARY SPENDING ASSUMPTIONS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 5 CURRENT SERVICES 0 GROWTH WITH POPULATION -5 GROWTH WITH NOMINAL GDP -10 -15 1995 2005 2015 2025 2035 2045 2055 2065 2075 32 ANALYTICAL PERSPECTIVES terms in the absence of policy changes. Many excise taxes are set in nominal terms, so collections decline as a share of GDP when there is inflation. Overall, Federal receipts are projected to rise by about 1 percentage point of GDP in the very long run. The starting point for these projections is the current ratio of Federal receipts to GDP. That ratio reached 20.5 percent in 1998, the highest level since World War II. This was not the result of new Federal taxes. Tax rates have been essentially unchanged since 1994, when the changes enacted in OBRA took effect. Since then, however, tax collections as a share of GDP have risen by two percentage points. The reasons for this increase are not yet fully understood. The rapid rise in the stock market, which has generated large capital gains for investors and made possible lucrative stock options and bonuses for executives, is generally believed to be a major factor. This Budget assumes that there will be some moderation in the ratio of receipts to GDP over the next few years. The share of revenues in the medium term is below the peak levels recently experienced. Even so, receipts are projected to remain above their historical average relative to the economy. Should this assumption prove overoptimistic, it would have a strong effect on the long-range budget projections. In Chart 2–5, the current services baseline is compared with two alternatives for receipts. In one, the share of receipts is assumed to return to the level posted in 1996, 19.2 percent of GDP; in the other, to the level in 1994, 18.4 percent of GDP. The return to these earlier levels is completed by 2001. Afterwards, taxes grow at the rates projected under current policies. The difference in the starting point for taxes can alter the outlook for the surplus/deficit quite dramatically. This is another example of how small differences in the primary surplus can eventually produce large effects on the total surplus/deficit because of mounting or falling interest expense. 4. What To Do With the Budget Surpluses. The current projections show the budget in surplus for several decades under a wide range of assumptions. These surpluses dramatically reduce debt held by the public, and therefore net interest outlays, which augments the surplus. In a sense, a budget surplus that is used to reduce debt feeds on itself by reducing future interest outlays. Thus, if these surpluses were limited by increased spending or reduced taxes, it would change the outlook. Chart 2–6 shows the budget’s path if it were held exactly in balance rather than being allowed to run surpluses. This would require policy changes to increase spending or reduce taxes. These changes could take two general forms. The spending or tax changes made possible by the surpluses could be purely temporary. This would be the case for tax rebates or one-time grants. If such changes were made, program spending and receipts would eventually return to their original baseline paths, although interest spending would be permanently higher. Alternatively, the spending increases or tax reductions could be permanently built into the budget. This would be the case if they took the form of tax rate cuts or increases in entitlements. Such changes are assumed to alter the baselines for Chart 2-5. ALTERNATIVE RECEIPTS ASSUMPTIONS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 5 CURRENT SERVICES 0 1996 RECEIPTS SHARE (19.2 PERCENT OF GDP) -5 -10 1994 RECEIPTS SHARE (18.4 PERCENT OF GDP) -15 -20 1995 2005 2015 2025 2035 2045 2055 2065 2075 33 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET outlays or receipts permanently, and have a larger longrun effect on the projected surplus. In both cases, the deficit returns sooner than it would if the surplus were used to reduce debt. 5. What Happens to the Debt? A surplus means the Government takes in more receipts from the public than it pays out in the form of Government outlays. The extra receipts are used to retire debt. This is not unlike a family paying off its mortgage, and like a family with a mortgage, the Government may eventually be free from debt. This has only happened once before in the history of the United States, and then only briefly a century and a half ago, but with the current level of projected surpluses, such an eventuality has become a possibility. When the budget window closes in 2009, the Administration projects that debt held by the public will have fallen to around 10 percent of GDP, lower than at any time since before U.S. entry into World War I. With surpluses running at around 21⁄2 percent to 3 percent of GDP in the Administration’s projections, it is obvious where the trend is headed. At this rate, within a few years after 2009, the entire debt held by the public would be repaid. At that point, further surpluses would no longer be used to retire Federal debt; instead, they would be accumulated in the form of Federal assets. As the Government accumulated financial reserves, these reserves would earn interest which would add to the surplus, further adding to the assets. In the long-run budget projections, the asset continues to build up until shifts in the underlying budgetary position cause the surplus gradually to unwind. Eventually, a deficit reappears and the asset is drawn down; ultimately, Federal debt is issued again. It is a measure of the severity of the impending demographic pressures that the national asset does not grow into the indefinite future—which it could, just as easily as did the national debt in the adverse projections of just a few years ago. Such an outcome is unlikely to happen—certainly in the simple form sketched here—but it stems from a reasonable desire to avoid making policy judgments. The projections imply that with sufficient discipline, the Federal debt could be repaid under an extension of current budget policies. It would require a change in policy to avoid that outcome. Chart 2–7 compares the current services baseline with a scenario in which spending is permanently increased or taxes permanently cut when Federal debt held by the public reaches zero. Without the national asset, the deficit reappears much sooner. The interest earned by the asset is no longer available to fill the budgetary hole when the drain of future entitlement claims begins to mount. 6. Productivity: Productivity growth in the U.S. economy slowed down after 1973. This slowdown is responsible for the slower rise in U.S. real incomes since that time. Productivity growth is affected by changes in the budget surplus/deficit which influence national saving, but many other factors influence it as well. The surplus/ deficit in turn is affected by changes in productivity growth which affect the size of the economy, and hence future receipts. Two alternative scenarios illustrate Chart 2-6. ALTERNATIVE USES OF THE SURPLUS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 5 CURRENT SERVICES 0 -5 SURPLUS USED FOR TEMPORARY TAX REBATES OR SPENDING INCREASES -10 SURPLUS USED FOR CONTINUING TAX CUTS OR SPENDING INCREASES -15 -20 1995 2005 2015 2025 2035 2045 2055 2065 2075 34 ANALYTICAL PERSPECTIVES Chart 2-7. ALTERNATIVE ASSUMPTIONS ABOUT A FEDERAL ASSET SURPLUS(+)/DEFICIT (-) AS A PERCENT OF GDP 5 CURRENT SERVICES 0 -5 NO ASSET IS ALLOWED TO ACCUMULATE -10 -15 -20 1995 2005 2015 2025 2035 2045 2055 2065 2075 Chart 2-8. ALTERNATIVE PRODUCTIVITY ASSUMPTIONS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 50 40 HALF PERCENT HIGHER PRODUCTIVITY GROWTH 30 20 10 0 CURRENT SERVICES -10 -20 -30 HALF PERCENT LOWER PRODUCTIVITY GROWTH -40 -50 -60 -70 1995 2005 2015 2025 2035 2045 2055 2065 2075 35 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET what would happen to the budget deficit if productivity growth were either higher or lower than assumed. A higher rate of growth would make the task of preserving a balanced budget much easier; indeed, it would permit expanded spending or reduced taxes without threatening to drive the budget back into deficit. A lower productivity growth rate would have the opposite effect. Chart 2–8 shows how the surplus/deficit varies with changes of one-half percentage point of average productivity growth in either direction. 7. Population: In the long run, shifting demographic patterns are the main source of change in these projections. The changing rate of population growth feeds into real economic growth through its effect on labor supply and employment. Changing demographic patterns also affect entitlement spending, contributing to the surge of spending expected for Social Security, Medicare, and Medicaid. The key assumptions underlying these demographic projections concern future fertility, mortality and immigration. • The main reason for the projected slowdown in population growth is the expected continuation of a low fertility rate. Since 1990, the number of births per woman in the United States has averaged between 2.0 and 2.1—slightly below the replacement rate needed to maintain a constant population. The fertility rate was even lower than this in the 1970s and 1980s. The demographic projections assume that fertility will average around 1.9 births per woman in the future. Fertility is hard to predict. Both the baby boom in the 1940s and 1950s and the baby bust in the 1960s and 1970s surprised demographers. A return to higher fertility rates is possible, but so is another drop in fertility. The U.S. fertility rate has never fallen below 1.7, but such low rates have been observed recently in some European countries. Chart 2–9 shows the effects of alternative fertility assumptions on the surplus/deficit; higher fertility contributes to a larger labor force, increased aggregate incomes, and revenues; and hence increases the projected surplus. Lower fertility has the opposite effect. • The increasing proportion of the elderly in the U.S. population is due to both lower fertility, which reduces the number of children per adult, and longer lifespans. Since 1970, the average lifespan for U.S. women has increased from 74.9 years to 79.4 years, and it is projected to rise to 80.4 years by 2010. Men do not live as long as women on average, but their lifespan has also increased, from 67.1 years in 1970 to 73.1 years in 1995, and it is expected to reach 74.9 years by 2010. Longer lifespans mean that more people will live to receive Social Security and Medicare benefits, and will receive them for a longer time. If, on the other hand, the U.S. population were to experience no further reductions in mortality from current levels, the shorter lifespans would help to improve the surplus/deficit. Conversely, if the population lives longer than now expected, the Chart 2-9. ALTERNATIVE FERTILITY ASSUMPTIONS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 5 HIGHER FERTILITY 0 CURRENT SERVICES -5 LOWER FERTILITY -10 1995 2005 2015 2025 2035 2045 2055 2065 2075 36 ANALYTICAL PERSPECTIVES Chart 2-10. ALTERNATIVE MORTALITY ASSUMPTIONS SURPLUS (+)/DEFICIT (-) AS A PERCENT OF GDP 5 SHORTER LIFE EXPECTANCY 0 CURRENT SERVICES -5 LONGER LIFE EXPECTANCY -10 -15 1995 2005 2015 2025 outlook for the surplus/deficit would worsen. This is illustrated in Chart 2–10. • A final factor influencing long-run projections is the rate of immigration. The United States is an open society. In the 19th century, a huge wave of immigration helped build the country; the last two decades of the 20th century have witnessed another burst of immigration. The net flow of legal immigrants has been averaging around 850,000 per year since 1992, while illegal immigration adds to these figures. This is the highest absolute rate in U.S. history, but as a percentage of population it is only about a third as high as immigration was in 1901–1910. Chart 2–11 presents alternatives in which future immigration is held to zero and allowed to rise 50 percent above and 50 percent below the intermediate actuarial assumption in the Social Security Trustees’ Report. Conclusion.—Under President Clinton, the long-run budget outlook has improved significantly. When this Administration took office, the deficit was projected to spiral out of control early in the next century, reaching levels never seen before except temporarily during major wars. The outlook now is drastically different. Under current policy assumptions, last year’s surplus marks the beginning of a period of sustained budget surpluses. Eventually, without further reforms to the entitlement programs, a return to budget deficits is 2035 2045 2055 2065 2075 projected. How soon that will occur is difficult to estimate. Avoiding a quick return to deficits will require budget discipline. Both Social Security and Medicare continue to confront long-run deficits in their respective Trust Funds, which must be addressed regardless of the prospects for the unified surplus. But the favorable outlook for the unified budget should make it easier to solve these difficult problems. Actuarial Balance in the Social Security and Medicare Trust Funds The Trustees for the Social Security and Hospital Insurance Trust Funds issue annual reports that include projections of income and outgo for these funds over a 75-year period. These projections are based on different methods and assumptions than the long-run budget projections presented above, although the projections do rely on a common set of assumptions for population growth and labor force growth after the year 2009. Even with these differences, the message is similar: the retirement of the baby-boom generation coupled with expected high rates of growth in per capita health care costs will exhaust the Trust Funds unless further remedial action is taken. The Trustees’ reports feature the 75-year actuarial balance of the Trust Funds as a summary measure of their financial status. For each Trust Fund, the balance is calculated as the change in receipts or program benefits (expressed as a percentage of taxable payroll) 37 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET that would be needed to preserve a small positive balance in the Trust Fund at the end of 75 years. Table 2–3 shows the changes in the 75-year actuarial balances of the Social Security and Medicare Trust Funds from 1997 to 1998. There were only relatively small changes in the projected balances last year for the OASDI Trust Funds, but there was a large improve- ment in the HI Trust Fund balance. This change incorporates the expected effects of the Balanced Budget Agreement enacted in 1997, which made numerous changes in Medicare. The reforms in the Agreement have extended the projected solvency of the Trust Fund from 2001 until 2008. Chart 2-11. ALTERNATIVE IMMIGRATION ASSUMPTIONS PERCENT OF GDP 5 HIGHER NET IMMIGRATION CURRENT SERVICES 0 -5 LOWER NET IMMIGRATION -10 -15 ZERO NET IMMIGRATION -20 -25 1995 Table 2–3. 2005 2015 2025 2035 2045 2055 2065 2075 CHANGE IN 75–YEAR ACTUARIAL BALANCE FOR OASDI AND HI TRUST FUNDS (INTERMEDIATE ASSUMPTIONS) (As a percent of taxable payroll) OASI DI OASDI HI Actuarial balance in 1997 Trustees’ Report ............................................................ Changes in balance due to changes in:. Legislation .................................................................................................................. Valuation period ........................................................................................................ Economic and demographic assumptions ................................................................ Technical and other assumptions ............................................................................. –1.84 –0.39 –2.23 –4.32 0.00 –0.07 0.10 0.00 0.00 –0.01 0.01 0.01 0.00 –0.08 0.11 0.01 2.10 –0.10 –0.08 0.30 Total changes ....................................................................................................... 0.03 0.01 0.04 2.22 Actuarial balance in 1998 Trustees’ Report ............................................................ –1.81 –0.38 –2.19 –2.10 38 ANALYTICAL PERSPECTIVES PART III—NATIONAL WEALTH AND WELFARE Unlike a private corporation, the Federal Government routinely invests in ways that do not add directly to its assets. For example, Federal grants are frequently used to fund capital projects by State or local governments for highways and other purposes. Such investments are valuable to the public, which pays for them with taxes, but they are not owned by the Federal Government and would not show up on a conventional Federal balance sheet. The Federal Government also invests in education and research and development (R&D). These outlays contribute to future productivity and are analogous to an investment in physical capital. Indeed, economists have computed stocks of human and knowledge capital to reflect the accumulation of such investments. Nonetheless, such hypothetical capital stocks are obviously not owned by the Federal Government, nor would they appear on a balance sheet. To show the importance of these kinds of issues, Table 2–4 presents a national balance sheet. It includes estimates of national wealth classified into three categories: physical assets, education capital, and R&D capital. The Federal Government has made contributions to each of these categories of capital, and these contributions are shown separately in the table. Data in this table are especially uncertain, because of the strong assumptions needed to prepare the estimates. The conclusion of the table is that Federal investments are responsible for about 71⁄2 percent of total national wealth. This may seem like a small fraction, but it represents a large volume of capital $4.8 trillion. The Federal contribution is down from around 9 percent in the mid-1980s, and from around 12 percent in 1960. Much of this reflects the shrinking size of the defense capital stocks, which have gone from 12 percent of GDP to under 9 percent since the end of the Cold War. Physical Assets: The physical assets in the table include stocks of plant and equipment, office buildings, residential structures, land, and government’s physical assets such as military hardware, office buildings, and highways. Automobiles and consumer appliances are also included in this category. The total amount of such capital is vast, around $27 trillion in 1998; by comparison, GDP was only about $8.5 trillion. The Federal Government’s contribution to this stock of capital includes its own physical assets plus $1.0 trillion in accumulated grants to State and local governments for capital projects. The Federal Government has financed about one-fourth of the physical capital held by other levels of government. Education Capital: Economists have developed the concept of human capital to reflect the notion that individuals and society invest in people as well as in physical assets. Investment in education is a good example of how human capital is accumulated. This table includes an estimate of the stock of capital represented by the Nation’s investment in education. The estimate is based on the cost of replacing the years of schooling embodied in the U.S. population aged 16 and over; in other words, the idea is to measure how much it would cost to reeducate the U.S. workforce at today’s prices (rather than its original cost). This is more meaningful economically than the historical cost, and is comparable to the measures of physical capital presented earlier. Although this is a relatively crude measure, it does provide a rough order of magnitude of the current value of the investment in education. According to this measure, the stock of education capital amounted to $31 trillion in 1998, of which about 3 percent was financed by the Federal Government. It exceeds the total value of the Nation’s privately owned stock of physical capital. The main investors in education capital have been State and local governments, parents, and students themselves (who forgo earning opportunities in order to acquire education). Even broader concepts of human capital have been suggested. Not all useful training occurs in a schoolroom or in formal training programs at work. Much informal learning occurs within families or on the job, but measuring its value is very difficult. However, labor compensation amounts to over two thirds of national income, and thinking of labor income as the product of human capital suggests that the total value of human capital might be two times the estimated value of physical capital. Thus, the estimates offered here are in a sense conservative, because they reflect only the costs of acquiring formal education and training. Research and Development Capital: Research and Development can also be thought of as an investment, because R&D represents a current expenditure that is made in the expectation of earning a future return. After adjusting for depreciation, the flow of R&D investment can be added up to provide an estimate of the current R&D stock.10 That stock is estimated to have been about $2 trillion in 1998. Although this is a large amount of research, it is a relatively small portion of total National wealth. Of this stock, 43 percent was funded by the Federal Government. Liabilities: When considering how much the United States owes as a Nation, the debts that Americans owe to one another cancel out. This means they do not belong in Table 2–4, but it does not mean they are unimportant. (An unwise buildup in debt, most of which was owed to other Americans, was partly responsible for the recession of 1990–1991 and the sluggishness of the early stages of the recovery that followed.) The only debt 10 R&D depreciates in the sense that the economic value of applied research and development tends to decline with the passage of time, as still newer ideas move the technological frontier. 39 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET Table 2–4. NATIONAL WEALTH (As of the end of the fiscal year, in trillions of 1998 dollars) 1960 1965 1970 1975 1980 1985 1990 1995 1996 1997 1998 ASSETS Publicly Owned Physical Assets: Structures and Equipment Publicly Owned Physical Assets: Structures and Equipment ............................................................................ Federally Owned or Financed ...................................................................... Federally Owned ........................................................................................... Grants to State and Local Government ....................................................... Funded by State and Local Governments ................................................... Other Federal Assets ............................................................................................. 2.1 1.2 1.1 0.1 0.9 0.8 2.4 1.3 1.1 0.2 1.1 0.7 2.9 1.5 1.1 0.3 1.5 0.7 3.5 1.5 1.0 0.5 2.0 0.9 3.7 1.5 0.9 0.6 2.1 1.5 3.9 1.8 1.1 0.7 2.1 1.5 4.2 1.9 1.2 0.8 2.3 1.2 4.6 2.0 1.1 0.9 2.6 0.9 4.7 2.0 1.1 0.9 2.7 1.0 4.8 2.0 1.1 1.0 2.8 1.0 4.8 2.0 1.0 1.0 2.8 0.9 Subtotal ..................................................................................................... 2.9 3.2 3.6 4.4 5.2 5.4 5.5 5.5 5.7 5.7 5.7 Privately Owned Physical Assets: Reproducible Assets .............................................................................................. Residential Structures ........................................................................................ Nonresidential Plant and Equipment ................................................................ Inventories .......................................................................................................... Consumer Durables ........................................................................................... Land ........................................................................................................................ 6.8 2.6 2.7 0.6 0.8 2.0 7.8 3.0 3.1 0.7 0.9 2.4 9.6 3.6 3.9 0.9 1.2 2.8 12.2 4.6 5.1 1.1 1.4 3.8 15.7 6.2 6.4 1.3 1.6 5.6 16.5 6.5 7.1 1.2 1.8 6.2 18.5 7.3 7.7 1.3 2.2 6.0 20.0 8.1 8.2 1.3 2.4 4.7 20.5 8.3 8.4 1.3 2.4 4.7 21.1 8.6 8.7 1.4 2.5 5.0 21.9 8.9 9.1 1.4 2.6 5.3 Subtotal .......................................................................................................... 8.8 10.2 12.4 16.0 21.2 22.7 24.5 24.7 25.3 26.1 27.2 Education Capital: Federally Financed ................................................................................................. Financed from Other Sources ............................................................................... 0.1 6.0 0.1 7.7 0.2 10.3 0.3 12.7 0.4 16.4 0.6 19.6 0.7 24.9 0.8 27.1 0.8 28.0 0.9 29.1 0.9 30.5 Subtotal .............................................................................................................. 6.1 7.8 10.6 13.0 16.8 20.2 25.6 27.9 28.9 29.9 31.4 Research and Development Capital: Federally Financed R&D ....................................................................................... R&D Financed from Other Sources ...................................................................... 0.2 0.1 0.3 0.2 0.5 0.3 0.5 0.4 0.6 0.5 0.7 0.6 0.8 0.8 0.9 1.0 0.9 1.1 0.9 1.2 0.9 1.2 Subtotal .............................................................................................................. 0.3 0.5 0.8 0.9 1.0 1.3 1.6 1.9 2.0 2.1 2.1 Total Assets ................................................................................................. Net Claims of Foreigners on U.S. ............................................................................. 18.0 –0.1 21.7 –0.2 27.3 –0.2 34.3 –0.1 44.2 –0.3 49.6 0.0 57.1 0.7 60.0 1.3 61.8 1.7 63.9 2.0 66.5 2.3 Balance ......................................................................................................... 18.2 21.8 27.5 34.4 44.6 49.6 56.4 58.7 60.0 61.9 64.2 100.5 709.1 0.5 12.3 112.4 673.0 0.6 11.5 134.0 714.0 0.8 10.3 159.2 786.7 1.2 9.5 195.2 856.0 2.2 9.1 207.3 816.3 3.2 9.1 225.1 817.8 3.9 8.3 222.4 763.6 4.4 7.9 225.5 753.1 4.6 7.9 230.5 746.2 4.7 7.7 237.0 748.1 4.8 7.4 ADDENDA: Per Capita (thousands of dollars) .............................................................................. Ratio to GDP (percent) .............................................................................................. Total Federally Funded Capital (trillions of 1998 dollars) ........................................ Percent of National Wealth ........................................................................................ that appears in Table 2–4 is the debt that Americans owe to foreign investors. America’s foreign debt has been increasing rapidly in recent years, because of the continuing deficit in the U.S. current account, but even so the size of this debt remains small compared with the total stock of U.S. assets. It amounted to 3.6 percent of net national wealth in 1998. Most Federal debt does not appear in Table 2–4 because it is held by Americans; only that portion of the Federal debt held by foreigners is included. However, comparing the Federal Government’s net liabilities with total national wealth gives another indication of the relative magnitude of the imbalance in the Government’s accounts. Currently, the Federal net asset imbalance, as estimated in Table 2–1, amounts to 5.0 percent of total U.S. wealth as shown in Table 2–4. Trends in National Wealth The inflation-adjusted net stock of wealth in the United States at the end of 1998 was about $64 trillion. Since 1980, it has increased in real terms at an average annual rate of 2.0 percent per year—less than half the 4.6 percent real growth rate it averaged from 1960 to 1980. Public physical capital formation slowed down even more between the two periods. Since 1980, public physical capital has increased at an annual rate of only 0.6 percent, compared with 3.0 percent over the previous 20 years. The net stock of private nonresidential plant and equipment grew 1.9 percent per year from 1980 to 1998, compared with 4.4 percent in the 1960s and 1970s; and the stock of business inventories increased less than 0.2 percent per year. However, private nonresidential fixed capital has increased more rapidly since 40 ANALYTICAL PERSPECTIVES 1992—2.8 percent per year—reflecting the recent investment boom. The accumulation of education capital, as measured here, has also slowed down since 1980, but not as much. It grew at an average rate of 5.2 percent per year in the 1960s and 1970s, about 3/4 percentage point faster than the average rate of growth in private physical capital during the same period. Since 1980, education capital has grown at a 3.5 percent annual rate. This reflects the extra resources devoted to schooling in this period, and the fact that such resources were increasing in economic value. R&D stocks have grown at about 4.1 percent per year since 1980, the fastest growth rate for any major category of investment over this period, but slower than the growth of R&D in the 1960s and 1970s. Federal policies contributed to the slowdown in capital formation that occurred after 1980. Federal investment decisions, as reflected in Table 2–4, obviously were important, but the Federal Government also contributes to wealth in ways that cannot be easily captured in a formal presentation. Monetary policy affects the rate and direction of capital formation in the short run, and regulatory and tax policies also affect how capital is invested, as do the Federal Government’s policies on credit assistance and insurance. One important channel of influence is the Federal budget surplus/deficit, which determines the size of Federal saving when it is positive or the Federal borrowing requirement when it is negative. Had deficits been smaller in the 1980s, there would have been a much smaller gap between Federal liabilities and assets than is shown in Table 2–1. It is also likely that, had the more than $3 trillion in added Federal debt since 1980 been avoided, a significant share of these funds would have gone into private investment. National wealth might have been 2 to 4 percent larger in 1998 had fiscal policy avoided the buildup in the debt. available over an extended period. Such indicators make it easier to draw valid comparisons and evaluate trends. In some cases, however, this meant choosing indicators with significant limitations. The individual measures in this table are influenced to varying degrees by many Government policies and programs, as well as by external factors beyond the Government’s control. They do not measure the outcomes of Government policies, because they do not show the direct results of Government activities, but they do provide a quantitative measure of the progress or lack of progress in reaching some of the ultimate values that government policy is intended to promote. Such a table can serve two functions. First, it highlights areas where the Federal Government might need to modify its current practices or consider new approaches. Where there are clear signs of deteriorating conditions, corrective action might be appropriate. Second, the table provides a context for evaluating other data on Government activities. For example, Government actions that weaken its own financial position may be appropriate when they promote a broader social objective. An example of this occurs during economic recessions, when reductions in tax collections lead to increased government borrowing that adds to Federal liabilities. This decline in Federal net assets, however, provides an automatic stabilizer for the private sector. State and local governments and private budgets are strengthened by allowing the Federal budget to go into deficit. More stringent Federal budgetary controls could be used to hold down Federal borrowing during such periods, but only at the risk of aggravating the downturn and weakening the other sectors. The Government cannot avoid making such tradeoffs because of its size and the broad ranging effects of its actions. Monitoring these effects and incorporating them in the Government’s policy making is a major challenge. Social Indicators An Interactive Analytical Framework There are certain broad responsibilities that are unique to the Federal Government. Especially important are fostering healthy economic conditions, promoting health and social welfare, and protecting the environment. Table 2–5 offers a rough cut of information that can be useful in assessing how well the Federal Government has been doing in promoting these general objectives. The indicators shown here are a limited subset drawn from the vast array of available data on conditions in the United States. In choosing indicators for this table, priority was given to measures that were consistently No single framework can encompass all of the factors that affect the financial condition of the Federal Government. Nor can any framework serve as a substitute for actual analysis. Nevertheless, the framework presented here offers a useful way to examine the financial aspects of Federal policies. Increased Federal support for investment, the promotion of national saving through fiscal policy, and other Administration policies to enhance economic growth are expected to promote national wealth and improve the future financial condition of the Federal Government. As that occurs, the efforts will be revealed in these tables. Other Federal Influences on Economic Growth 41 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET Table 2–5. General categories ECONOMIC AND SOCIAL INDICATORS Specific measures Economic: Living Standards .......... Economic Security ....... Employment Prospects Wealth Creation ........... Innovation ..................... Social: Families ........................ Safe Communities ........ Health and Illness ........ Learning ........................ Participation .................. Environment: Air Quality ..................... Water Quality ............... Real GDP per person (1992 dollars) ................................ average annual percent change .................................... Median Income (1997 dollars):. All Households .................................................................... Married Couple Families .................................................... Female Householder, No Spouse Present ........................ Income Share of Lower Three Quintiles (percent) ........... Poverty Rate (percent) 1 ..................................................... Civilian Unemployment (percent) ....................................... CPI–U (percent Change) .................................................... Increase in Total Payroll Employment (millions) ............... Managerial or Professional Jobs (percent of total) ........... Net National Saving Rate (percent of GDP) ..................... Patents Issued to U.S. Residents (thousands) ................. Multifactor Productivity (average annual percent change) Children Living with Female Householder, No Spouse Present (percent of all children) .................................... Violent Crime Rate (per 100,000 population) 2 ................. Murder Rate (per 100,000 population) 2 ............................ Juvenile Crime (murders and nonnegligent manslaughter per 100,000 persons age 14 to 17) .............................. Infant Mortality (per 1000 Live Births) ............................... Low Birthweight [<2,500 gms] Babies (percent) ............... Life Expectancy at birth (years) ......................................... Cigarette Smokers (percent population 18 and older) ...... Bed Disability Days (average days per person) ............... High School Graduates (persent of population 25 and older) .............................................................................. College Graduates (percent of population 25 and older) National Assessment of Educational Progress 3. Mathematics High School Seniors ................................ Science High School Seniors ........................................ Voting for President (percent eligible population) ............. Voting for Congress (percent eligible population) ............. Individual Charitable Giving per Capita (1997 dollars) ..... Nitrogen Oxide Emissions (thousand short tons) ............. Sulfur Dioxide Emissions (thousand short tons) ............... Lead Emissions (thousand short tons) .............................. Population Served by Secondary Treatment or Better (millions) ......................................................................... 1960 1965 1970 1975 1980 1985 1990 1995 1996 1997 1998 12,516 0.3 14,828 5.1 16,566 –1.1 17,935 –1.4 20,268 –1.5 22,321 2.7 24,545 0.2 25,690 1.3 26,336 2.5 27,136 3.0 27,915 2.9 NA 29,274 14,794 34.8 22.2 5.5 1.7 –0.5 NA 10.8 42.1 1.0 NA 34,095 16,576 35.2 17.3 4.5 1.6 2.9 NA 12.6 53.9 3.1 33,942 40,867 19,792 35.2 12.6 4.9 5.8 –0.5 NA 8.7 49.8 1.0 33,699 42,458 19,546 35.2 12.3 8.5 9.1 0.4 NA 6.7 40.2 1.2 34,538 45,129 20,297 34.5 13.0 7.1 13.5 0.2 NA 7.5 40.5 0.7 35,229 46,390 20,376 32.7 14.0 7.2 3.5 2.5 24.1 6.2 43.2 0.6 36,770 48,991 20,793 32.0 13.5 5.5 5.4 0.3 25.8 4.4 52.6 0.2 35,887 49,563 20,738 30.3 13.8 5.6 2.8 2.2 28.3 5.3 64.2 0.2 36,306 50,848 20,368 30.0 13.7 5.4 2.9 2.8 28.8 5.8 69.2 0.6 37,005 51,591 21,023 29.8 13.3 5.0 2.3 3.4 29.1 6.6 69.7 NA NA NA NA NA NA 4.5 1.6 2.9 29.6 6.6 NA NA 9 160 5 10 199 5 12 364 8 16 482 10 19 597 10 20 557 8 22 732 9 24 685 8 23 634 7 23 611 7 NA NA NA NA 26.0 7.7 69.7 NA 6.0 NA 24.7 8.3 70.2 42.4 6.2 NA 20.0 7.9 70.8 39.5 6.1 11 16.1 7.4 72.6 36.4 6.6 13 12.6 6.8 73.7 33.2 7.0 10 10.6 6.8 74.7 30.1 6.1 24 9.2 7.0 75.4 25.5 6.2 24 7.6 7.3 75.8 24.7 6.1 20 7.3 7.4 76.1 NA NA NA NA NA NA NA NA NA NA NA NA NA NA 44.6 8.4 49.0 9.4 55.2 11.0 62.5 13.9 68.6 17.0 73.9 19.4 77.6 21.3 81.7 23.0 81.7 23.6 82.1 23.9 NA NA NA NA 62.8 58.5 213 NA NA NA NA 255 NA 305 NA 43.5 306 302 293 NA NA 325 300 286 52.8 47.6 354 301 288 NA NA 373 305 290 NA 33.1 455 307 295 NA NA 456 307 296 49.0 45.8 470 NA NA NA NA NA NA NA NA 33.4 NA 14,140 22,245 NA 17,424 26,380 NA 21,369 31,161 221 23,151 28,011 160 24,875 25,905 74 23,488 23,230 23 23,436 23,678 5 23,768 19,189 4 23,391 19,836 4 23,576 NA 4 NA NA NA NA NA NA NA NA 134 155 166 165 NA NA 1 The poverty rate does not reflect noncash government transfers such as Medicaid or food stamps. 2 Not all crimes are reported, and the fraction that go unreported may have varied over time. 3 Some data from the national educational assessments have been interpolated. TECHNICAL NOTE: SOURCES OF DATA AND METHOD OF ESTIMATING Federally Owned Assets and Liabilities Assets: Financial Assets: The source of data is the Federal Reserve Board’s Flow-of-Funds Accounts. Two adjustments were made to these data. First, U.S. Government holdings of financial assets were consolidated with the holdings of the monetary authority, i.e., the Federal Reserve System. Second, the gold stock was revalued using the market value for gold. Physical Assets: Fixed Reproducible Capital: Estimates were developed from the OMB historical data base for physical capital outlays. The data base extends back to 1940 and was supplemented by data from other selected sources for 1915–1939. The source data are in current dollars. To estimate investment flows in constant dol- lars, it is necessary to deflate the nominal investment series. This was done using price deflators for Federal purchases of durables and structures from the National Income and Product Accounts. Fixed Nonreproducible Capital: Historical estimates for 1960–1985 were based on estimates in Michael J. Boskin, Marc S. Robinson, and Alan M. Huber, ‘‘Government Saving, Capital Formation and Wealth in the United States, 1947–1985,’’ published in The Measurement of Saving, Investment, and Wealth, edited by Robert E. Lipsey and Helen Stone Tice (The University of Chicago Press, 1989). Estimates were updated using changes in the value of private land from the Flow-of-Funds Balance Sheets and in the Producer Price Index for Crude Energy Materials. 42 ANALYTICAL PERSPECTIVES Liabilities: Financial Liabilities: The principal source of data is the Federal Reserve’s Flow-of-Funds Accounts. Insurance Liabilities: Sources of data are the OMB Deposit Insurance Model and the OMB Pension Guarantee Model. Historical data on liabilities for deposit insurance were also drawn from the CBO’s study, The Economic Effects of the Savings and Loan Crisis, issued January 1992. Pension Liabilities: For 1979–1997, the estimates are the actuarial accrued liabilities as reported in the annual reports for the Civil Service Retirement System, the Federal Employees Retirement System, and the Military Retirement System (adjusted for inflation). Estimates for the years before 1979 are extrapolations. The estimate for 1998 is a projection. Long-Run Budget Projections The long-run budget projections are based on longrun demographic and economic projections. A simplified model of the Federal budget developed at OMB computes the budgetary implications of this forecast. Demographic and Economic Projections: For the years 1999–2009, the assumptions are identical to those used in the budget. These budget assumptions reflect the President’s policy proposals. The long-run projections extend these budget assumptions by holding constant inflation, interest rates, and unemployment at the levels assumed in the final year of the budget. Population growth and labor force growth are extended using the intermediate assumptions from the 1998 Social Security Trustees’ report. The projected rate of growth for real GDP is built up from the labor force assumptions and an assumed rate of productivity growth. The assumed rate of productivity growth is held constant at the average rate of growth implied by the budget’s economic assumptions. Budget Projections: For the budget period through 2009, the projections follow the budget. Beyond the budget horizon, receipts are projected using simple rules of thumb linking income taxes, payroll taxes, excise taxes, and other receipts to projected tax bases derived from the economic forecast. Outlays are computed in different ways. Discretionary spending is projected according to current services assumptions in which it grows at the rate of inflation. As an alternative, discretionary spending is also projected to grow at the rate of inflation plus population. Social Security, Medicare, and Federal pensions are projected using the most recent actuarial forecasts available at the time the budget was prepared. These projections are repriced using Administration inflation assumptions. Other entitlement programs are projected based on rules of thumb linking program spending to elements of the economic and demographic forecast such as the poverty rate. National Balance Sheet Data Publicly Owned Physical Assets: Basic sources of data for the federally owned or financed stocks of capital are the investment flows described in Chapter 6. Fed- eral grants for State and local government capital were added, together with adjustments for inflation and depreciation in the same way as described above for direct Federal investment. Data for total State and local government capital come from the revised capital stock data prepared by the Bureau of Economic Analysis. Privately Owned Physical Assets: Data are from the Flow-of-Funds national balance sheets and from the private net capital stock estimates prepared by the Bureau of Economic Analysis. Values for 1998 were extrapolated using investment data from the National Income and Product Accounts. Education Capital: The stock of education capital is computed by valuing the cost of replacing the total years of education embodied in the U.S. population 16 years of age and older at the current cost of providing schooling. The estimated cost includes both direct expenditures in the private and public sectors and an estimate of students’ forgone earnings, i.e., it reflects the opportunity cost of education. The historical estimates of education capital presented in this section differ from previously published estimates because of the incorporation of revised estimates of students’ forgone earnings. These are now based on the year-round, full-time earnings of 18–24 year olds with selected educational attainment levels. These year-round earnings are reduced by 25 percent because students are usually out of school three months of the year. For high school students, these adjusted earnings are further reduced by the unemployment rate for 16–17 year olds; for college students, by the unemployment rate for 20–24 year olds. Yearly earnings by age and educational attainment are from Money Income in the United States, series P60, published by the Bureau of the Census. For this presentation, Federal investment in education capital is a portion of the Federal outlays included in the conduct of education and training. This portion includes direct Federal outlays and grants for elementary, secondary, and vocational education and for higher education. The data exclude Federal outlays for physical capital at educational institutions and for research and development conducted at colleges and universities because these outlays are classified elsewhere as investment in physical capital and investment in R&D capital. The data also exclude outlays under the GI Bill; outlays for graduate and post-graduate education spending in HHS, Defense and Agriculture; and most outlays for vocational training. Data on investment in education financed from other sources come from educational institution reports on the sources of their funds, published in U.S. Department of Education, Digest of Education Statistics. Nominal expenditures were deflated by the GDP chainweighted price index to convert them to constant dollar values. Education capital is assumed not to depreciate, but to be retired when a person dies. An education capital stock computed using this method with different source data can be found in Walter McMahon, ‘‘Relative Returns To Human and Physical Capital in the U.S. 43 2. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET and Efficient Investment Strategies,’’ Economics of Education Review, Vol. 10, No. 4, 1991. The method is described in detail in Walter McMahon, Investment in Higher Education, Lexington Books, 1974. Research and Development Capital: The stock of R&D capital financed by the Federal Government was developed from a data base that measures the conduct of R&D. The data exclude Federal outlays for physical capital used in R&D because such outlays are classified elsewhere as investment in federally financed physical capital. Nominal outlays were deflated using the GDP deflator to convert them to constant dollar values. Federally funded capital stock estimates were prepared using the perpetual inventory method in which annual investment flows are cumulated to arrive at a capital stock. This stock was adjusted for depreciation by assuming an annual rate of depreciation of 10 percent on the outstanding balance for applied research and development. Basic research is assumed not to depreciate. The 1993 Budget contains additional details on the estimates of the total federally financed R&D stock, as well as its national defense and nondefense components (see Budget for Fiscal Year 1993, January 1992, Part Three, pages 39–40). A similar method was used to estimate the stock of R&D capital financed from sources other than the Federal Government. The component financed by universities, colleges, and other nonprofit organizations is estimated based on data from the National Science Foundation, Surveys of Science Resources. The industryfinanced R&D stock component is estimated from that source and from the U.S. Department of Labor, The Impact of Research and Development on Productivity Growth, Bulletin 2331, September 1989. Experimental estimates of R&D capital stocks have recently been prepared by BEA. The results are described in ‘‘A Satellite Account for Research and Development,’’ Survey of Current Business, November 1994. These BEA estimates are lower than those presented here primarily because BEA assumes that the stock of basic research depreciates, while the estimates in Table 2–4 assume that basic research does not depreciate. BEA also assumes a slightly higher rate of depreciation for applied research and development, 11 percent, compared with the 10 percent rate used here. Social Indicators The main sources for the data in this table are the Government statistical agencies. Generally, the data are publicly available in the annual Economic Report of the President and the Statistical Abstract of the United States. FEDERAL RECEIPTS AND COLLECTIONS 45 3. FEDERAL RECEIPTS Receipts (budget and off-budget) are taxes and other collections from the public that result from the exercise of the Government’s sovereign or governmental powers. The difference between receipts and outlays determines the surplus or deficit. Growth in receipts.—Total receipts in 2000 are estimated to be $1,883.0 billion, an increase of $76.7 billion Table 3–1. or 4.2 percent relative to 1999. This increase is largely due to assumed increases in incomes resulting from both real economic growth and inflation. Receipts are projected to grow at an average annual rate of 3.6 percent between 2000 and 2004, rising to $2,165.5 billion. As a share of GDP, receipts are projected to decline from 20.6 percent in 1999 to 20.0 percent in 2004. RECEIPTS BY SOURCE—SUMMARY (In billions of dollars) Estimate Source 1998 actual 1999 2000 2001 2002 2003 2004 Individual income taxes ..................................................................... Corporation income taxes ................................................................. Social insurance and retirement receipts ......................................... (On-budget) ................................................................................... (Off-budget) ................................................................................... Excise taxes ...................................................................................... Estate and gift taxes ......................................................................... Customs duties .................................................................................. Miscellaneous receipts ...................................................................... 828.6 188.7 571.8 (156.0) (415.8) 57.7 24.1 18.3 32.7 868.9 182.2 608.8 (164.8) (444.0) 68.1 25.9 17.7 34.7 899.7 189.4 636.5 (171.2) (465.3) 69.9 27.0 18.4 42.1 912.5 196.6 660.3 (177.7) (482.6) 70.8 28.4 20.0 44.9 942.8 203.4 686.3 (184.6) (501.8) 72.3 30.5 21.4 50.3 970.7 212.3 712.0 (189.8) (522.2) 73.8 31.6 23.0 51.7 1,017.7 221.5 739.2 (196.3) (542.9) 75.4 33.9 24.9 53.0 Total receipts .......................................................................... (On-budget) .......................................................................... (Off-budget) .......................................................................... 1,721.8 (1,306.0) (415.8) 1,806.3 (1,362.3) (444.0) 1,883.0 (1,417.7) ( 465.3) 1,933.3 (1,450.7) (482.6) 2,007.1 (1,505.3) (501.8) 2,075.0 (1,552.8) (522.2) 2,165.5 (1,622.6) (542.9) Table 3–2. CHANGES IN RECEIPTS (In billions of dollars) Estimate 1 1999 2000 2001 2002 2003 2004 Receipts under tax rates and structure in effect January 1, 1999 ...................................................... Social security (OASDI) taxable earnings base increases:. $72,600 to $76,200 on Jan. 1, 2000 ..................................................................................................... $76,200 to $79,200 on Jan. 1, 2001 ..................................................................................................... $79,200 to $81,900 on Jan. 1, 2002 ..................................................................................................... $81,900 to $84,600 on Jan. 1, 2003 ..................................................................................................... $84,600 to $87,000 on Jan. 1, 2004 ..................................................................................................... Proposals 2 ...................................................................................................................................................... 1,806.6 1,870.1 1,918.8 1,988.3 2,052.8 2,139.5 ................ ................ ................ ................ ................ –0.3 1.7 ................ ................ ................ ................ 11.2 4.4 1.4 ................ ................ ................ 8.7 4.8 3.6 1.3 ................ ................ 9.1 5.2 3.9 3.2 1.3 ................ 8.7 5.7 4.3 3.5 3.2 1.1 8.2 Total, receipts under existing and proposed legislation ........................................................ 1,806.3 1,883.0 1,933.3 2,007.1 2,075.0 2,165.5 1 These estimates assume a social security taxable earnings base of $72,600 through 2004. 2 Net of income offsets. 47 48 ANALYTICAL PERSPECTIVES ENACTED LEGISLATION Several laws were enacted in 1998 that have an effect on governmental receipts. The major legislative changes affecting receipts are described below. Transportation Equity Act for the 21st Century.—This Act, which was signed by President Clinton on June 9, 1998, represents a significant achievement in the Administration’s efforts to meet our country’s transportation needs in the next century. By building on the initiatives established in the Intermodal Surface Transportation Efficiency Act of 1991, this Act combines the continuation and improvement of current programs with new initiatives to meet the challenges of improving safety as traffic continues to increase, protecting and enhancing communities and the natural environment as we provide transportation, and advancing America’s economic growth and competitiveness domestically and internationally through efficient and flexible transportation. The major provisions of the Act affecting receipts are described below: Extend highway-related taxes.—The excise taxes levied on gasoline (other than aviation gasoline), diesel fuel, and special motor fuels, which were scheduled to fall to 4.4 cents per gallon (or comparable rates in the case of special motor fuels) after September 30, 1999, are extended at their prior law rates (with a 0.1-centper-gallon reduction, reflecting the expiration of the LUST Trust Fund tax, on April 1, 2005) through September 30, 2005. Highway Trust Fund excise taxes on heavy truck tires and the sale and the use of heavy trucks, which were scheduled to expire on September 30, 1999, are extended at their prior law rates through September 30, 2005. Extend and modify ethanol tax benefit.—Under prior law, ethanol fuels were eligible for a tax benefit equal to 54 cents per gallon, which could be claimed through reduced excise taxes paid on motor fuels, as well as through income tax credits. The authority to claim the credit against income taxes was scheduled to expire after December 31, 2000 and the authority to claim the benefit through reduced excise taxes was scheduled to expire after September 30, 2000. This Act extends the authority to claim the credit against income taxes through December 31, 2007; the authority to claim the benefit through reduced excise taxes is extended through September 30, 2007. In addition, the tax benefit is reduced to 53 cents per gallon effective January 1, 2001, 52 cents per gallon effective January 1, 2003, and 51 cents per gallon effective January 1, 2005. Repeal excise tax on railroad diesel fuel.—The 1.25 cents-per-gallon tax on railroad diesel fuel, which was scheduled to expire after September 30, 1999, is repealed effective November 1, 1998. Extend and increase transfers of motorboat and small engine fuels taxes to the Aquatic Resources Trust Fund.—Under prior law, 11.5 cents per gallon of the 18.4-cents-per-gallon tax on gasoline and special motor fuels used in motorboats and small engines was trans- ferred to the Aquatic Resources Trust Fund. This Act extends the transfer, which was scheduled to expire after September 30, 1998, through September 30, 2005. In addition, the amount transferred is increased to 13.0 cents per gallon effective October 1, 2001 and to 13.5 cents per gallon effective October 1, 2003. Modify tax treatment of transportation benefits.— Under prior law, up to $175 per month (for 1998) of employer-provided parking benefits were excludable from an employee’s gross income, regardless of whether the benefits were offered in addition to, or in lieu of, any compensation otherwise payable to the employee. In contrast, up to $65 per month (for 1998) of employerprovided transit and vanpool benefits were excludable from an employee’s gross income, but only if the benefits were provided in addition to, and not in lieu of, any compensation otherwise payable to the employee. The dollar limits for both benefits were indexed annually for inflation. Under this Act, effective for taxable years beginning after December 31, 1997, employers are allowed to offer employees the option of electing cash compensation in lieu of any qualified transportation benefit, or a combination of any of these benefits. In addition, effective for taxable years beginning after December 31, 2001, the exclusion for transit and vanpool benefits is increased to $100 per month, with annual indexing thereafter. The Act also eliminates the 1999 inflation adjustment to the dollar limit on transportation benefits. Simplify motor fuels tax refund procedures.—Under prior law, gasoline and diesel fuel excise tax refunds were administered separately, subject to separate quarterly minimum filing thresholds. Effective for claims filed after September 30, 1998, refunds of gasoline and diesel fuel excise taxes may be aggregated, and a claim may be filed once a single $750 minimum is reached (determined on a year-to-date basis). Internal Revenue Service Restructuring and Reform Act of 1998.—This Act, which was signed by President Clinton on July 22, 1998, sets in motion the most comprehensive overhaul of IRS’s internal operations in more than four decades, puts new emphasis on electronic filing, and puts in place new rights and protections for taxpayers when dealing with the IRS. The major provisions of the Act are described below. Reorganization of Structure and Management of the IRS Reorganize and revise the mission of the IRS.—The IRS Commissioner is required to replace the existing three-tier geographic structure of the IRS (national, regional, district) with organizational units serving particular groups of taxpayers. The IRS is also required to review and restate its mission to place greater emphasis on serving the public and meeting taxpayer’s needs. An independent Appeals function must also be established within the IRS. 3. 49 FEDERAL RECEIPTS Establish IRS Oversight Board.—A nine-member IRS Oversight Board is established within the Treasury Department. The responsibilities of the Board include the following: (1) Review and approval of IRS strategic plans. (2) Review operational functions of the IRS. (3) Recommend candidates for IRS Commissioner and review the selection, evaluation, and compensation of senior managers. (4) Review and approve plans for any major future reorganization of the IRS. (5) Review and approve the Commissioner’s IRS budget request to be submitted to the Department of the Treasury. This budget request also will be submitted to Congress concurrent with the President’s annual budget request for the IRS. (6) Ensure the proper treatment of taxpayers by IRS employees. Modify appointment and duties of IRS Commissioner.—The IRS Commissioner is nominated by the President and confirmed by the Senate, as under prior law. However, under this Act the Commissioner is appointed to a five-year term and is required to have a demonstrated ability in management. Rename and expand the authority of the Taxpayer Advocate.—The Taxpayer Advocate position is renamed the National Taxpayer Advocate. The individual appointed to this position cannot have been an officer or employee of the IRS during the two-year period ending with the individual’s appointment, and must agree not to accept employment with the IRS (outside of the Taxpayer Advocate organization) during the five-year period beginning with the date the individual ceases to be the National Taxpayer Advocate. The person in this position is responsible for appointing at least one local taxpayer advocate for each State and has expanded authority to issue taxpayer assistance orders (orders that may be issued when a taxpayer is suffering or is about to suffer from a significant hardship as a result of the manner in which the laws are being administered by IRS). In determining whether to issue a taxpayer assistance order, the National Taxpayer Advocate is authorized to consider, among other factors, the following: unreasonable delays in resolving the taxpayer’s account problems; immediate threats of substantial adverse action (such as the seizure of a residence to pay overdue taxes); the likelihood of irreparable harm if relief is not granted; whether the taxpayer will have to pay significant professional fees if relief is not granted; and the possibility of long-term adverse impact on the taxpayer. Establish position of Treasury Inspector General for Tax Administration.—The Office of the IRS Chief Inspector is to be terminated and the powers of the IRS Chief Inspector are to be transferred to the new position of Treasury Inspector General (IG) for Tax Administration. The new IG for Tax is given all the powers under the Inspector General Act for matters relating to the IRS, may conduct an audit or investigation of the IRS upon the written request of the Commissioner or the Board, and is required to establish a toll-free telephone number for taxpayers to confidentially register complaints of misconduct by IRS employees. Prohibit Executive Branch influence over taxpayer audits.—The President, Vice President, and most Cabinet officers, other than the Attorney General, are prohibited from requesting, directly or indirectly, an officer or employee of the IRS to either conduct or terminate an audit or investigation of any particular taxpayer with respect to the tax liability of the taxpayer. Improve personnel flexibilities.—The modification of employee personnel rules applicable to the IRS will help the IRS recruit and retain the private sector expertise it needs to fill critical technical and senior management positions and will provide important tools that will enable the IRS to accomplish its restructuring efforts. Electronic Filing The Act states that it is the policy of the Congress to promote paperless filing, with the long-range goal of having at least 80 percent of all tax returns filed electronically by 2007. Toward that end, the IRS is required to develop a strategic plan concerning electronic filing within 180 days after July 22, 1998, to establish an ‘‘electronic commerce advisory group,’’ and to report periodically to Congress on progress toward meeting the 80 percent goal. The Act also requires that the IRS develop procedures to: (1) accept digital or other electronic signatures, (2) accept all forms electronically for periods beginning after December 31, 1999, to the extent practicable, (3) acknowledge electronic filing in a manner similar to certified or registered mail, (4) provide forms and other IRS documents on the Internet, (5) electronically authorize disclosure of return information to the return preparer, (6) allow taxpayers on-line access to account information, subject to suitable safeguards, and (7) implement a fully return-free tax system for certain taxpayers for taxable years beginning after 2007. In addition, the deadline for filing information returns with the IRS is extended from February 28 until March 31 of the year following the tax year to which the return relates, for returns filed electronically. The Secretary of the Treasury is required to study and report to Congress by June 30, 1999, the effect of similarly extending the deadline for providing taxpayers with copies of information returns from January 31 to February 15 of the year following the tax year to which the return relates. Congressional Accountability for the IRS The Act consolidates Congressional oversight of the IRS by: (1) expanding the duties of the Joint Committee on Taxation (JCT) to include review and approval of all requests for General Accounting Office (GAO) investigations of the IRS (other than those from a committee chairperson or ranking member, those required by law, and those self-initiated by GAO); (2) requiring one annual joint review of the annual filing season and the progress of the IRS in meeting its objectives under the strategic and business plans, in improving taxpayer service and compliance, and on technology modernization; (3) stating that it is the sense of the Congress that IRS should place a high priority on resolving the 50 ANALYTICAL PERSPECTIVES century date change; (4) stating that it is the sense of the Congress that the IRS provide the Congress with an independent view of tax administration and that the tax-writing committees should hear from front-line technical experts at the IRS during the legislative process with respect to the administrability of pending amendments to the Internal Revenue Code; and (4) requiring that the IRS report to the House Committee on Ways and Means and the Senate Committee on Finance by March 1 of each year regarding sources of complexity in the administration of the Federal tax laws. Taxpayer Protection and Rights Burden of Proof Shift the burden of proof to the IRS in certain circumstances.—In any court proceeding with respect to a factual issue (applicable to income, estate, gift and generation-skipping transfer taxes), the burden of proof is shifted to the IRS if the taxpayer introduces credible evidence relevant to ascertaining his/her tax liability. The taxpayer has the burden of proving that the following conditions, which are necessary prerequisites to establishing that the burden of proof is on the IRS, have been met: (1) All items at issue must be substantiated by the taxpayer in accordance with the Internal Revenue Code and relevant regulations. (2) All records required by the Internal Revenue Code and regulations must be maintained by the taxpayer. (3) The taxpayer must cooperate with the IRS regarding reasonable requests for witnesses, information, documents, meetings and interviews. (4) Taxpayers other than individuals or estates must meet the net worth limitations (no more than $7 million) that apply to awarding attorney’s fees. This provision applies to court proceedings arising in connection with examinations commencing after July 22, 1998, or if there is no examination, to court proceedings arising in connection with taxable periods or events beginning or occurring after July 22, 1998. Proceedings by Taxpayers Expand authority to award costs and certain fees.— Any person who substantially prevails in a dispute related to taxes, interest, or penalties may be awarded reasonable administrative costs incurred before the IRS and reasonable litigation costs incurred in connection with any court proceeding. Individuals can receive an award of litigation and administrative costs only if their net worth does not exceed $2 million. Awards cannot exceed amounts actually paid or incurred, and attorney’s fees awarded cannot exceed a statutorily limited rate. Under prior law, taxpayers who were represented pro bono, and thus bore no actual attorney’s fees and costs, could not recover such amounts. This Act allows the awarding of attorney’s fees (in amounts up to the statutory limit) to persons who represent such taxpayers for no more than a nominal fee. The statutorily limited rate is increased from $110 per hour (indexed for inflation) to $125 per hour (indexed for inflation). The Act also clarifies that an award of attorney’s fees from the United States is permitted in actions for civil damages for unauthorized inspection or disclosure of taxpayer returns and return information only when the defendant is the United States and the plaintiff is a prevailing party. Other defendants (such as State employees or contractors) may be liable for attorney’s fees and costs in cases where the United States is not a party, whenever they are found to have made a wrongful disclosure. Finally, the Act provides that attorney’s fees and costs may be recovered if the taxpayer makes a ‘‘qualified offer’’ to the IRS, the IRS rejects the offer, and the ultimate resolution of the case is less favorable to the IRS than the rejected ‘‘qualified offer.’’ These provisions are effective for costs incurred and services performed after January 18, 1999. Expand civil damages for collection actions.—Taxpayers have the right to sue for damages if, in connection with any collection of Federal tax, any officer or employee of the IRS recklessly or intentionally disregards any provision of the Internal Revenue Code or any regulation thereunder. Recoverable damages are the lesser of actual, direct economic damages sustained, plus attorneys’ fees, or $1 million. Under prior law, actions could only be brought by the injured taxpayer (not by an injured third party) and could not be brought against any officer or employee of the IRS who negligently disregarded any provision of the Internal Revenue Code or any regulation thereunder. In addition, suit could not be brought against any officer or employee of the IRS who willfully violated the automatic stay or discharge provisions of the Bankruptcy Code. Effective for actions occurring after July 22, 1998, this Act expands the ability to sue for civil damages as follows: (1) A taxpayer may sue for up to $100,000 in civil damages caused by an officer or employee of the IRS who negligently disregards provisions of the Internal Revenue Code or any regulation thereunder in connection with the collection of Federal tax from the taxpayer. (2) A taxpayer may sue for up to $1 million in civil damages caused by an officer or employee of the IRS who willfully violates provisions of the Bankruptcy Code relating to automatic stays or discharges. (3) Injured third parties are permitted to sue for civil damages for unauthorized collection actions. Increase Tax Court’s ‘‘small case’’ limit.—Taxpayers may choose to contest many tax disputes in the Tax Court. Under prior law, special ‘‘small case procedures’’ applied to disputes involving $10,000 or less, if the taxpayer chose to utilize these procedures (and the Tax Court concurred). This Act increases the cap for small case treatment in the Tax Court from $10,000 to $50,000, effective for proceedings commencing after July 22, 1998. Allow actions for refund with respect to certain estates that have elected the installment method of payment.— Under the Internal Revenue Code, a taxpayer may bring a refund suit only if full payment of the assessed tax liability has been made. However, under certain conditions, the executor of an estate may pay the estate 3. FEDERAL RECEIPTS tax attributable to certain closely-held businesses over a 14-year period. These two rules can be in conflict, preventing electing estates from obtaining full relief in a refund jurisdiction. Effective for claims filed after July 22, 1998, this Act grants the courts refund jurisdiction to determine the correct liability of such an estate, so long as the estate has properly elected to pay in installments, all payments are current, the payments due have not been accelerated, there are no suits for declaratory judgment pending, and there are no outstanding deficiency notices against the estate. The Act also includes a number of technical and conforming amendments to implement this change. Modify appeals process with regard to adverse determinations regarding the tax-exempt status of certain bond issues.—Interest on debt incurred by States or local governments generally is excluded from gross income if the proceeds of the borrowing are used to carry out governmental functions of those entities and the debt is repaid with governmental funds. A jurisdiction that seeks to issue bonds can request a ruling from the IRS regarding the eligibility of such bonds for taxexemption. The prospective issuer can challenge the IRS’s determination (or failure to make a timely determination) in a declaratory judgment proceeding in the Tax Court. Under prior law there was no mechanism that explicitly allowed tax-exempt bond issuers examined by the IRS to appeal adverse examination determinations to the Appeals Division of the IRS as a matter of right. This Act directs the IRS to modify its administrative procedures to allow tax-exempt bond issuers examined by the IRS to appeal adverse examination determinations to the Appeals Division as a matter of right, effective July 22, 1998. These appeals must be heard by senior appeals officers having experience in resolving complex cases. Provide new remedy for third parties who claim that the IRS has filed an erroneous lien.—The Supreme Court held (Williams v. United States) that a third party who paid another person’s tax under protest to remove a lien on the third party’s property could bring a refund suit, because she had no other adequate administrative or judicial remedy. However, the Court left many important questions unresolved. This Act creates administrative and judicial remedies for a third party subject to an erroneous tax lien, effective July 22, 1998. Under this procedure, the owner of property (other than the taxpayer) can obtain a certificate discharging property from the Federal tax lien as a matter of right, provided certain conditions are met. The certificate of discharge enables the property owner to sell the property free and clear of the Federal tax lien in all circumstances. The Act also establishes a judicial cause of action for persons challenging a Federal tax lien. Relief for Innocent Spouses and Persons with Disabilities Relieve innocent spouse of liability in certain cases.— Spouses who file a joint tax return are each fully responsible for the accuracy of the return and for the 51 full tax liability, even if only one spouse earned the wages or income shown on the return. Under prior law, relief from liability was available for ‘‘innocent spouses’’ in certain circumstances, but the conditions were frequently hard to meet and the Tax Court did not have jurisdiction to review all denials of innocent spouse relief. This Act generally makes innocent spouse status easier to obtain by eliminating certain applicable dollar thresholds for understatements of tax; requiring that the understatement of tax be attributable to an erroneous item of the other spouse, rather than a grossly erroneous item as required under prior law; giving the IRS the discretion to provide equitable relief; and providing the Tax Court with jurisdiction to review the IRS’s denial of innocent spouse relief and to order appropriate relief. The Act also modifies the innocent spouse provision to permit a spouse who is divorced, legally separated, or living apart for 12 months, to elect to limit his/her liability for unpaid taxes on a joint return to his/her separate liability amount. Unless the electing taxpayer had knowledge, when the return was signed, that an item on the return was incorrect, such an electing taxpayer essentially is responsible for any deficiency only to the extent his/her own items contributed to the deficiency. The separate liability election must be made no later than two years after the date on which collection activities have begun with respect to the individual seeking the relief. Except in limited cases, the IRS is not permitted to collect the tax until the Tax Court case is final (although the running of the statute of limitations will be suspended while the Tax Court case is pending). Finally, the Act requires the IRS to develop a separate form with instructions for taxpayers to use in applying for innocent spouse relief by January 18, 1999. These changes apply to liability for tax arising after July 22, 1998, as well as to any liability arising on or before that date that remains unpaid on that date. Provide equitable tolling.—A refund claim that is not filed within certain specified time periods is rejected as untimely. The Supreme Court recently held (United States v. Brockamp) that these limitations periods cannot be extended, or ‘‘tolled,’’ for equitable reasons. This may lead to harsh results for some taxpayers, particularly when they fail to seek a refund because of a well-documented disability or similar compelling circumstance that prevents them from doing so. Consequently, this Act permits ‘‘equitable tolling’’ of the limitation period on claims for refund for the period of time during which an individual taxpayer is unable to manage his/her financial affairs because of a medically determined physical or mental disability that can be expected to result in death or to last for a continuous period of not less than 12 months. Tolling does not apply during periods in which the taxpayer’s spouse or another person is authorized to act on the taxpayer’s behalf in financial matters. The provision applies to periods of disability before, on, or after July 22, 1998, but does not apply to any claim for refund or credit that (without regard to the provision) is barred by the 52 operation of any law, including the statute of limitation, as of July 22, 1998. Provisions Relating to Interest and Penalties Allow ‘‘global’’ interest netting of underpayments and overpayments of tax.—The rate of interest charged taxpayers on their tax underpayments differs from the rate paid to taxpayers on overpayments. Under prior law, the IRS ameliorated the effect of this interest rate differential by ‘‘netting’’ offsetting underpayments and overpayments in some situations (that is, applying a net interest rate of zero on equivalent amounts of overpayment and underpayment); however, there was no authority to net when either the overpayment or the underpayment had been satisfied already (‘‘global’’ netting). This Act permits global interest netting for all taxes (not just income taxes), effective for interest applicable to periods beginning after July 22, 1998. It also applies to interest for periods beginning before that date if: (1) as of July 22, 1998, the statute of limitations has not expired with respect to either the underpayment or overpayment; (2) the taxpayer identifies the periods of underpayment and overpayment for which the zero rate applies; and (3) on or before December 31, 1999, the taxpayer asks the Secretary of the Treasury to apply the zero rate. Increase interest rate applicable to overpayments of tax by noncorporate taxpayers.—Under prior law, interest on overpayments of tax was payable at a rate equal to the Federal short term interest rate (AFR) plus two percentage points. Effective for interest payable on overpayments by noncorporate taxpayers after December 31, 1998, the rate is increased to the AFR plus three percentage points (the same rate applicable to underpayments of tax). The rate remains at AFR plus two percentage points for corporations. Mitigate failure to pay penalty during installment agreements.—Taxpayers who fail to pay their taxes are subject to a penalty of 0.5 percent per month on the unpaid amount, up to a maximum of 25 percent. Under prior law, taxpayers who made installment payments pursuant to an agreement with the IRS could also be subject to the penalty. Effective for installment agreement payments made after December 31, 1999, the penalty for failure to pay taxes applicable to the unpaid amount is reduced to 0.25 percent per month. Mitigate failure to deposit penalty.—Under prior law, deposits of payroll taxes were allocated to the earliest period for which such deposit was due. If a taxpayer missed or made an insufficient deposit for a given period, later deposits were first applied to satisfy the shortfall for the earlier period. Cascading penalties often resulted, as payments that would otherwise be sufficient to satisfy current liabilities were applied to satisfy earlier shortfalls. For deposits required to be made after January 18, 1999, this Act allows the taxpayer to designate the period to which each deposit is to be applied. The designation must be made no later than 90 days after the related IRS penalty notice is sent. For deposits required to be made after Decem- ANALYTICAL PERSPECTIVES ber 31, 2001, any deposit is to be applied to the most recent period to which the deposit relates, unless the taxpayer explicitly designates otherwise. Suspend interest and certain penalties if the IRS fails to contact the taxpayer.—In general, interest and penalties accrue during the period for which taxes are unpaid, without regard to whether the taxpayer is aware that tax is due. Effective for taxable years ending after July 22, 1998 and beginning before January 1, 2004, for taxpayers who file a timely return, the accrual of penalties and interest are suspended if the IRS has not sent the taxpayer a notice of deficiency within 18 months following the date which is the later of: (1) the due date of the return (without regard to extensions) or (2) the date on which the individual taxpayer timely filed the return. The provision applies only to individuals and does not apply to the failure to pay penalty, in the case of fraud, or with respect to criminal penalties. The suspension of interest and penalties continues until 21 days after the IRS sends a notice to the taxpayer specifically stating the taxpayer’s liability and the basis for the liability. Effective for taxable years beginning after December 31, 2003, the 18-month period is reduced to one year. Modify procedural requirements for imposition of penalties.—Under prior law the IRS was not required to show how penalties were computed on the notice of penalty and in some cases, penalties could be imposed without supervisory approval. Effective for notices issued and penalties assessed after December 31, 2000, this Act requires that each notice imposing a penalty include the name of the penalty, the code section imposing the penalty, and a computation of the penalty. In addition, unless excepted, all non-computer-generated penalties require the specific approval of IRS management. The provision does not apply to failure-to-file penalties, failure-to-pay penalties, or to penalties for failure to pay estimated tax. Permit personal delivery of 100-percent penalty notices.—Any person who willfully fails to collect, truthfully account for, and pay over any tax imposed by the Internal Revenue Code is liable for a penalty equal to the amount of the tax. Before the IRS may assess any such ‘‘100-percent penalty’’ it must mail a written preliminary notice informing the person of the proposed penalty. The mailing of such notice must precede any notice and demand for payment of the penalty by at least 60 days. Effective July 22, 1998, this Act permits personal delivery of such preliminary notices, as an alternative to delivery by mail. Modify procedural requirements for interest charges.— Effective for all notices issued by the IRS after December 31, 2000 that include an amount of interest required to be paid by the taxpayer, a detailed computation of the interest charges and a citation of the Code section under which such interest is imposed are required. Abate interest on underpayments of tax by taxpayers in Presidentially declared disaster areas.—Effective for disasters declared after December 31, 1997, with re- 3. FEDERAL RECEIPTS spect to taxable years beginning after December 31, 1997 (a provision of the Taxpayer Relief Act of 1997 had provided the same benefit to disasters declared during 1997), taxpayers located in a Presidentially declared disaster area do not have to pay interest on taxes due for the length of any extension for filing their tax returns granted by the Secretary of the Treasury. Protections for Taxpayers Subject to Audit or Collection Activities Establish formal procedures to insure due process in IRS collection actions.—The IRS is entitled to seize a taxpayer’s property by levy to pay the taxpayer’s tax liability. Effective for collections initiated after January 18, 1999, this Act establishes formal procedures designed to insure due process where the IRS seeks to collect taxes by levy. Under these procedures, the IRS is required to provide the taxpayer with a ‘‘Notice of intent to Levy’’ by personal delivery, by leaving it at the taxpayer’s dwelling or usual place of business, or by registered or certified mail, return receipt requested, at least 30 days before the taxpayer’s property is seized. During the 30-day period following issuance of the intent to levy, the taxpayer may demand a hearing before an appeals officer who has had no prior involvement with the taxpayer’s case. If such a hearing is requested, no levy may occur until a determination by the appeals officer is rendered. The determination of the appeals officer may be appealed to the Tax Court or, where appropriate, the Federal district court. No seizure of a dwelling that is the principal residence of the taxpayer, the taxpayer’s spouse, the taxpayer’s former spouse, or minor child is allowed without prior judicial approval. Extend confidentiality privilege to taxpayer communications with federally authorized practitioners.—The attorney-client privilege of confidentiality is extended to communications between taxpayers and individuals (in noncriminal proceedings) who are authorized under Federal law to practice before the IRS. The provision, which is effective with regard to communications made on or after July 22, 1998, does not apply to a written communication between federally authorized tax practitioners and any director, shareholder, officer, employee, agent, or representative of a corporation in connection with the promotion of any tax shelter. Limit financial status audit techniques.—Effective July 22, 1998, the IRS is prohibited from using financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the IRS has a reasonable indication that there is a likelihood of unreported income. Establish protections against the disclosure and improper use of computer software and source codes.— In a civil action, the IRS is prohibited from issuing a summons for any portion of any third-party tax-related computer source code unless certain requirements are satisfied. The Act also establishes a number of protections against the disclosure and improper use of 53 trade secrets and computer software and source code that come into possession of the IRS in the course of the examination of a taxpayer’s return. These protections generally are effective for summonses issued and computer software and source code acquired after July 22, 1998. Prohibit threat of audit to coerce tip reporting alternative commitment agreements.—Restaurants may enter into Tip Reporting Alternative Commitment (TRAC) agreements. A restaurant entering into a TRAC agreement is obligated to educate its employees on their tip reporting obligations, to institute formal tip reporting procedures, to fulfill all filing and record keeping requirements, and to pay and deposit taxes. In return, the IRS agrees to base the restaurant’s liability for employment taxes solely on reported tips and any unreported tips discovered during an IRS audit of an employee. Effective July 22, 1998, the IRS is required to instruct its employees that they may not threaten to audit any taxpayer in an attempt to coerce the taxpayer to enter into a TRAC agreement. Allow taxpayers to quash all third-party summonses.—Under prior law, summonses issued to ‘‘thirdparty recordkeepers’’ were subject to different procedures than other summonses: notice of the summons was required to be given to the taxpayer, and the taxpayer had an opportunity to bring a court proceeding to quash the summons, during which time the thirdparty recordkeeper was prohibited from complying with the summons. This Act expands the ‘‘third-party recordkeeper’’ procedures to apply to all summonses issued to persons other than the taxpayer. The provision is effective for summonses served after July 22, 1998. Permit service of summonses by mail.—This Act permits the IRS to serve summonses by certified or registered mail, as an alternative to the prior law requirement that all summonses be personally served. The provision is effective for summonses served after July 22, 1998. Provide notice of IRS contact with third party.—Third parties may be contacted by the IRS in connection with the examination of a taxpayer or the collection of the tax liability of the taxpayer. In general, under prior law, the IRS was required to notify the taxpayer of the service of summons on a third party within three days of the date of service. This Act provides that the IRS may not contact any person other than the taxpayer with respect to the determination or collection of the tax liability of the taxpayer without providing reasonable notice in advance to the taxpayer that the IRS may contact persons other than the taxpayer. This provision, which is effective with respect to contacts made after January 18, 1999, does not apply to criminal tax matters, if the collection of the tax liability is in jeopardy, if the Secretary determines that disclosure may involve reprisal against any person, or if the taxpayer authorized the contact. Require supervisory approval for certain liens, levies, and seizures.—Under prior law, supervisory approval of liens, levies or seizures was only required under cer- 54 tain circumstances. This Act requires the IRS to implement an approval process under which any lien, levy or seizure would, when appropriate, be approved by a supervisor, who would review the taxpayer’s information, verify that a balance is due, and affirm that a lien, levy or seizure is appropriate under the circumstances. Circumstances to be taken into account include the amount due and the value of the asset. The provision applies to automated collection system actions initiated after December 31, 2000 and to all other collections actions initiated after July 22, 1998. Modify levy exemption amounts.—IRS may levy on all non-exempt property of the taxpayer. Under prior law, property exempt from levy included up to $2,500 in value of fuel, provisions, furniture, and personal effects in the taxpayer’s household and up to $1,250 in value of books and tools necessary for the trade, business or profession of the taxpayer. This Act increases the value of personal effects exempt from levy to $6,250 and the value of books and tools exempt from levy to $3,125. These amounts are indexed annually for inflation and apply to levys issued after July 22, 1998. Require release of levy upon agreement that amount is uncollectible.—Effective for levys imposed after December 31, 1999, the IRS is required to release a wage levy as soon as practicable upon agreement with the taxpayer that the tax is not collectible. Suspend collection by levy during refund suit.—Generally, full payment of the tax at issue is a prerequisite to a refund suit (Flora v. United States), but this rule does not apply in the case of ‘‘divisible’’ taxes (such as employment taxes or the ‘‘100-percent penalty’’ under section 6672). Effective for refund suits brought with respect to taxable years beginning after December 31, 1998, this Act requires the IRS to suspend collection by levy of liabilities that are the subject of a refund suit during the pendency of the litigation. This only applies where refund suits can be brought without the full payment of the tax, i.e., divisible taxes. Collection by levy is suspended unless jeopardy exists or the taxpayer waives the suspension of collection in writing. The statute of limitations on collection is stayed for the period during which collection by levy is prohibited. Require review of jeopardy and termination assessments and jeopardy levies.—Special procedures allow the IRS to make jeopardy assessments or termination assessments in certain extraordinary circumstances; for instance, if the taxpayer is leaving or removing property from the United States or if assessment or collection would be jeopardized by delay. In jeopardy or termination situations, a levy may also be made without the 30-day notice of intent to levy that is ordinarily required. Jeopardy and termination assessments and jeopardy levies often involve difficult legal issues. This Act requires IRS Counsel review and approval before the IRS can make a jeopardy assessment, a termination assessment, or a jeopardy levy. If the Counsel’s approval is not obtained, the taxpayer is entitled to obtain abatement of the assessment or release of the levy, and, if the IRS fails to offer such relief, to appeal first ANALYTICAL PERSPECTIVES to the collections appeals process and then to the U.S. District Court. This provision is effective with respect to taxes assessed and levies made after July 22, 1998. Increase ‘‘superpriority’’ dollar limits.—A Federal tax lien attaches to all property and rights in property of the taxpayer, if the taxpayer fails to pay the assessed tax liability after notice and demand. However, the Federal tax lien is not valid as to certain ‘‘superpriority’’ interests. Two of these ‘‘superpriorities’’ are subject to dollar limitations. For example, under prior law, purchasers of personal property at a casual sale were protected against a Federal tax lien attached to such property to the extent the sale was for less than $250; protection for mechanics lienors who provide home improvement work for residential real property was $1,000. Effective July 22, 1998, this Act increases these dollar limits, which are indexed for inflation, to $1,000 and $5,000, respectively. Under prior law, superpriorities were granted to banks and building and loan associations that made passbook loans to their customers, provided that those institutions retained the passbooks in their possession until the loan was completely paid off. This Act clarifies the superpriorities law to reflect current banking practices, where a passbook-type loan may be made even though an actual passbook is not used. Waive early withdrawal penalty for IRS levies on retirement plans.—Early withdrawals from qualified retirement plans and Individual Retirement Accounts (IRAs) that are includible in the gross income of the taxpayer generally are subject to a 10-percent early withdrawal tax, unless an exception to the tax applies. Effective for distributions after December 31, 1999, this Act provides an exception from the 10-percent early withdrawal tax for amounts withdrawn from an employer-sponsored retirement plan or an IRA that are subject to a levy by the IRS. The exception applies only if the plan or IRA is levied; it does not apply if the taxpayer withdraws funds to pay taxes in the absence of a levy, or if the taxpayer withdraws funds in order to release a levy on other interests. Prohibit sales of seized property at less than minimum bid.—A minimum bid price must be established for seized property offered for sale. Effective for sales after July 22, 1998, the IRS is prohibited from selling seized property for less than the minimum bid price. Require a written accounting of all sales of seized property.—The IRS is required to provide a written accounting of all sales of seized property to the taxpayer, effective for seizures occurring after July 22, 1998. The accounting must include a receipt for the amount credited to the taxpayer’s account. Implement a uniform asset disposal mechanism.—The IRS must sell property seized by levy either by public auction or by public sale under sealed bids. These sales are often conducted by the revenue officer charged with collecting the tax liability. By July 22, 2000, this Act requires the IRS to implement a uniform asset disposal mechanism for sales of seized property. The disposal mechanism should be designed to remove any participa- 3. FEDERAL RECEIPTS tion in the sale by revenue officers and outsourcing of the disposal mechanism may be considered. Codify administrative procedures for seizures.—The IRS Manual provides general guidelines for seizure actions, requiring that if it is determined that the taxpayer’s equity in the seized property is insufficient to yield net proceeds from sale to apply to the unpaid tax, the revenue officer must immediately release the seized property. This Act codifies these administrative procedures effective July 22, 1998. Establish procedures for seizure of residences and businesses.—Effective July 22, 1998, the following procedures apply with respect to the seizure of residences and businesses: (1) Seizure of any nonrental residential real property to satisfy an unpaid liability of $5,000 or less (including interest and penalties) generally is prohibited. (2) All other payment options must be exhausted before the taxpayer’s business assets or principal residence may be seized. (3) Seizure of a principal residence is permitted only if approved in writing by a U.S. District Court. (4) Future income derived from the sale of fish or wildlife under specified State permits or licenses must be taken into account in evaluating other payment options before seizing the taxpayer’s business assets. Require disclosures relating to extension of statute of limitations by agreement.— Under prior law, taxpayers and the IRS could agree in writing to extend statute of limitations on assessment or collection, either for a specified period or for an indefinite period. Under this Act, the statute of limitations on collections may no longer be extended by agreement between the taxpayer and the IRS, except in connection with an installment agreement, but the extension is only for the period for which the installment agreement by its terms extends beyond the end of the otherwise applicable 10year period plus 90 days. The Act also requires that on each occasion that the taxpayer is requested by the IRS to extend the statue of limitations on assessment, the IRS must notify the taxpayer of the taxpayer’s right to refuse to extend the statute of limitations or to limit the extension to particular issues or to a particular time period. These requirements generally apply to requests to extend the statute of limitations made after December 31, 1999. Expand authority of the IRS to accept offers-in-compromise.—The IRS is authorized to compromise a taxpayer’s tax liability for less than the full amount due. In general, there are two grounds on which an offerin-compromise can be made: doubt as to the taxpayer’s liability for the full amount owed, or doubt as to the taxpayer’s ability to pay the full amount owed. This Act requires the IRS to develop and publish schedules of national and local living allowances, taking into account variations in the cost of living in different areas. This information is to be used to ensure that taxpayers entering into an offer-in-compromise will have adequate means to provide for basic living expenses. The IRS is prohibited from rejecting an offer-in-compromise from a low-income taxpayer solely on the basis of the amount 55 of the offer. The Act also prohibits the IRS from collecting a tax liability by levy during any period that a taxpayer’s offer-in-compromise for that liability is being processed, during the 30 days following rejection of an offer, during any period in which an appeal of the rejection of an offer is being considered, and while an installment agreement is pending. The Act also provides that the IRS must implement procedures to review all proposed rejections of taxpayer offers-in-compromise and requests for installment agreements prior to the rejection being communicated to the taxpayer. These changes generally are effective for offers-in-compromise and installment agreements submitted after July 22, 1998. The provision suspending levy is effective with respect to offers-in-compromise pending on or made after December 31, 1999. Require notice of deficiency to specify Tax Court filing deadlines.—Taxpayers must file a petition with the Tax Court within 90 days after the notice of deficiency is mailed (150 days if the person is outside the United States). Because timely filing in Tax Court is a jurisdictional prerequisite, the IRS cannot extend the filing period, nor can the Tax Court hear the case of a taxpayer who relies on erroneous information from the IRS and files too late. This Act requires the IRS to include on each notice of deficiency the date it determines is the last day on which the taxpayer may file a Tax Court petition (including the last day for a taxpayer who is outside the United States). Any petition filed by the later of the statutory date or the date shown on the notice is treated as timely filed. The provision applies to notices mailed after December 31, 1998. Refund or credit of overpayments before final determination.—The IRS may not take action to collect a deficiency during the period a taxpayer may petition the Tax Court, or, if the taxpayer petitions the Tax court, until the decision of the Tax Court becomes final. Actions to collect a deficiency attempted during this period may be enjoined, but under prior law, there was no authority for ordering the refund of any amount collected by the IRS during the prohibited period. If a taxpayer contested a deficiency in the Tax Court, no credit or refund of income tax for the contested taxable year generally could be made, except in accordance with a final decision of the Tax Court. Where the Tax Court determined that an overpayment had been made and a refund was due, and a portion of the decision was appealed, there was no provision for the refund of any portion of any overpayment that was not contested in the appeal. Effective July 22, 1998, this Act provides that a proper court may order a refund of any amount that was collected within the period during which collection of the deficiency by levy or other proceeding is prohibited. This Act also allows the refund of any overpayment determined by the Tax Court, to the extent the overpayment is not contested on appeal. Modify IRS procedures related to appeal of examinations and collections.—Effective July 22, 1998, this Act 56 ANALYTICAL PERSPECTIVES codifies existing IRS procedures with respect to early referrals to Appeals and the Collections Appeals Process. This Act also codifies the existing Alternative Dispute Resolution procedures, as modified by eliminating the prior law dollar threshold of more than $10 million in dispute. Codify certain Fair Debt Collection procedures.—Government agencies, including the IRS, are generally exempt from the Fair Debt Collection Practices Act (FDCPA). Effective July 22, 1998, this Act applies to the IRS the FDCPA restrictions relating to communication with the taxpayer/debtor (prohibition on telephone calls outside the hours of 8:00 a.m. to 9:00 p.m. local time) and prohibitions on harassing or abusing a debtor. Ensure availability of installment agreements.—The IRS is authorized to enter agreements permitting taxpayers to pay taxes in installments if such an agreement will ‘‘facilitate collection’’ of the liability. The IRS has discretion to determine when an installment agreement is appropriate. This Act requires the IRS to enter into an installment agreement (at the taxpayer’s option) for liabilities of $10,000 or less, provided certain conditions are met. The provision is effective July 22, 1998. Prohibit requests to waive rights to bring actions.— Effective July 22, 1998, the government cannot ask a taxpayer to waive the right to sue the United States or one of its employees for actions taken concerning a tax matter, in order to settle another tax matter unless the taxpayer knowingly and voluntarily waives the right or the request is made to an authorized taxpayer representative (such as an attorney). Disclosures to Taxpayers Require explanation of joint and several liability.— In general, spouses who file a joint tax return are jointly and severally liable for the tax due. Thus each is fully responsible for the accuracy of the return and the full amount of the liability, even if only one spouse earned the wages or income that is shown on the return. This Act requires the IRS to establish procedures no later than January 18, 1999, to alert married taxpayers clearly of their joint and several liability on all appropriate publications and instructions. Provide explanation of taxpayer rights in interviews with the IRS.—The IRS is required to rewrite Publication 1 (Your Rights as a Taxpayer) no later than January 18, 1999. The revision must inform taxpayers more clearly of their rights to be represented by a representative, and, if the taxpayer is so represented, that interviews with the IRS may not proceed without the presence of the representative unless the taxpayer consents. Require disclosure of criteria for examination selection.—This Act requires that the IRS add to Publication 1 (Your Rights as a Taxpayer) a statement setting forth, in simple and nontechnical terms, the criteria and procedures for selecting taxpayers for examination. The statement must not include any information that would be detrimental to law enforcement, and must specify the general procedures used by the IRS, including whether taxpayers are selected for examination on the basis of information in the media or from informants. These additions to Publication 1 must be made no later than January 18, 1999. Provide explanation of appeals and collection process.—The IRS is required to provide to taxpayers a description of the entire appeals and collection process, from examination through collection, including the assistance available to taxpayers from the Taxpayer Advocate at various points in the process. This information must be provided with the first letter of proposed deficiency that allows the taxpayer an opportunity for administrative review in the IRS Office of Appeals, beginnng no later than January 18, 1999. Provide explanation of reason for refund disallowance.—Effective January 18, 1999, the IRS is required to notify the taxpayer of the specific reasons for the disallowance (or partial disallowance) of a refund claim. Provide statements regarding installment agreements.—Effective July 1, 2000, the IRS is required to send every taxpayer in an installment agreement an annual statement of the initial balance owed, the payments made during the year, and the remaining balance. Provide notification of change in tax matters partner.—In general, the tax treatment of items of partnership income, loss, deductions and credits are determined at the partnership level in a unified partnership proceeding rather than in separate proceedings with each partner. In providing notice to taxpayers with respect to partnership proceedings, the IRS relies on information furnished by a party designated as the tax matters partner (TMP) of the partnership. The TMP is required to keep each partner informed of all administrative and judicial proceedings with respect to the partnership. Under certain circumstances, the IRS may require the resignation of the incumbent TMP and designate another partner as the TMP of the partnership. Effective for selections of TMPs made by the IRS after July 22, 1998, this Act requires the IRS to notify all partners of any resignation of the TMP that is required by the IRS, and to notify the partners of any successor TMP. Provide description of conditions under which taxpayer returns may be disclosed.—Effective July 22, 1998, this Act requires that instruction booklets for general tax forms include a description of conditions under which tax return information may be disclosed outside the IRS (including to States). Provide procedure for disclosure of Chief Counsel advice.—This Act establishes a structured process by which the IRS will make certain work products, designated as ‘‘Chief Counsel Advice,’’ open to public inspection on an ongoing basis. The provision, which applies to Chief Counsel Advice issued after October 20, 1998, is designed to protect taxpayer privacy while allowing the public inspection of public documents in a manner generally consistent with the mechanism for the public inspection of written determinations. 3. 57 FEDERAL RECEIPTS Provide clinics for low-income taxpayers.—Low-income individuals frequently have difficulty complying with their tax obligations or resolving disputes over their tax liabilities. Providing tax services to such individuals through clinics that offer such services for a nominal fee would improve compliance with the tax laws and should be encouraged. The Secretary of the Treasury is authorized to provide up to $6 million per year in matching grants (no more than $100,000 per year per eligible clinic) to certain low-income taxpayer clinics, effective July 22, 1998. To be eligible, a clinic may charge no more than a nominal fee to either represent low-income taxpayers in controversies with the IRS or to provide tax information to individuals for whom English is a second language. Require cataloging of complaints.—Beginning in 1997, the IRS is required to make an annual report to Congress regarding allegations of misconduct by IRS employees. Effective January 1, 2000, the IRS is required to maintain records of taxpayer complaints of misconduct by IRS employees, on an individual employee basis, although individual records are not to be listed in the report to Congress. Facilitate archiving of IRS records.—The IRS, like all other Federal agencies, must create, maintain, and preserve agency records, and must transfer significant and historical records to the National Archives and Records Administration (NARA) for retention or disposal. However, tax returns and return information are confidential and can be disclosed only pursuant to limited exceptions. Under prior law, there was no exception authorizing the disclosure of return information to NARA. This Act provides an exception to the disclosure rules, authorizing the IRS to disclose tax returns and return information to officers or employees of NARA, upon written request from the U.S. Archivist, for purposes of the appraisal of such records for destruction or retention. The prohibitions on, and penalties for, unauthorized re-disclosure of such information apply to NARA. The provision is effective for requests made by the Archivist after July 22, 1998. Modify payment of taxes.—The Secretary of the Treasury is authorized to accept payments by checks or money orders, as provided in regulations. Under prior law, checks or money orders were made payable to the ‘‘Internal Revenue Service.’’ Under this Act the Secretary of the Treasury or his delegate is required to amend the rules, regulations, and procedures to allow payment of taxes by check or money order to be made payable to the ‘‘United States Treasury,’’ effective July 22, 1998. Clarify authority to prescribe manner of making elections.—Except as otherwise provided by statute, prior law provided that elections under the Internal Revenue Code must be made in such manner as the Secretary of the Treasury ‘‘shall by regulations or forms prescribe.’’ This Act clarifies that, except as otherwise provided, the Secretary may prescribe the manner of making any election by any reasonable means. This change is effective July 22, 1998. Additional Provisions Eliminate 18-month holding period for capital gains.—Under the Taxpayer Relief Act of 1997 (TRA97), the maximum capital gains tax rate for individuals generally was reduced from 28 percent to 20 percent (10 percent for individuals in the 15-percent tax bracket) effective May 7, 1997. The prior law maximum tax rate of 28 percent was retained for collectibles and, effective July 29, 1997, for assets held between 1 year and 18 months. In addition, TRA97 provided a maximum rate of 25 percent for the long-term capital gain attributable to depreciation from real estate held more than 18 months. Under this Act, effective January 1, 1998, property held by an individual for more than one year (rather than 18 months) is eligible for the lower maximum capital gains tax rates (10, 20, and 25 percent) provided in TRA97. Modify tax treatment of meals provided for the convenience of the employer.—Under prior law, meals provided on the business premises to employees were excluded from the employees’ income and fully deductible to the employer if substantially all of the employees (interpreted to be approximately 90 percent) were provided such meals for the convenience of the employer. Effective for taxable years beginning before, on, or after July 22, 1998, all meals furnished to employees at a place of business are excluded from the employees’ income and fully deductible to the employer if more than one-half of the employees are provided such meals for the convenience of the employer. Revenue Offsets Overrule Schmidt Baking with respect to vacation and severance pay.—Any method or arrangement that has the effect of deferring the receipt of compensation or other benefits for employees is treated as a deferred compensation plan. In general, contributions under a deferred compensation plan (other than certain pension, profit-sharing and similar plans) are deductible to the employer in the taxable year in which an amount attributable to the contribution is includible in the income of the employee. Temporary Treasury regulations provide that a plan, method, or arrangement that defers the receipt of compensation or benefits by the employee more than 21⁄2 months after the end of the employer’s taxable year in which the services creating the right to such compensation or benefits are performed, is to be treated as a deferred compensation plan. The Tax Court recently addressed the issue of when vacation pay and severance pay are considered deferred compensation in Schmidt Baking Co., Inc.,. In that case the taxpayer, who was an accrual basis taxpayer with a fiscal year that ended December 28, 1991, funded its accrued vacation and severance pay liabilities for 1991 by purchasing an irrevocable letter of credit on March 13, 1992. The parties stipulated that the letter of credit represented a transfer of substantially vested interest in property to employees and that the fair market value of such interest was includible in the employees’ gross incomes for 1992 as a result of the transfer. 58 The Tax Court held that the purchase of the letter of credit, and the resulting income inclusion, constituted payment of the vacation and severance pay within the 21⁄2 month period, thus the vacation and severance pay were not treated as deferred compensation. This ruling allowed the employer to deduct the cost in 1991, and the employees to pay the taxes on the benefits in 1992. This Act overrules Schmidt Baking Co., Inc., by providing that for purposes of determining whether an item of compensation (including vacation pay and severance pay), is deferred compensation, the compensation is not considered to be paid or received until actually received by the employee. Actual receipt does not include an amount transferred as a loan, refundable deposit, or contingent payment. Also, amounts set aside in a trust for employees are not considered to be actually received by the employee. This change is effective for taxable years ending after July 22, 1998. Freeze grandfather status of stapled (or ‘‘pairedshare’’) Real Estate Investment Trusts (REITs).—REITs generally are limited to owning passive investments in real estate and certain securities. Prior to 1984, certain ‘‘stapled’’ REITs were paired with subchapter C corporations and traded in tandem as a single unit. This effectively allowed these stapled REITs to circumvent the restrictions on operating active businesses. In the Deficit Reduction Act of 1984, Congress restricted REITs’ ability to avoid these investment limitations by providing that stapled entities must be treated as one entity for purposes of determining qualification under the REIT rules. However, Congress grandfathered the existing stapled REITs indefinitely. This Act limits the ability of grandfathered stapled REITs to grow and actively manage certain types of properties within the stapled structure. Specifically, for purposes of determining whether any grandfathered entity is a REIT, the stapled entities (and certain subsidiary entities) are treated as one entity with respect to properties acquired on or after March 26, 1998 and with respect to activities or services relating to such properties that are undertaken or performed by one of the entities on or after such date. Preclude certain taxpayers from prematurely claiming losses from receivables.—In general, dealers in securities are required to use a mark-to-market method of accounting. Under this method, securities that are inventory in the hands of the dealer must be included in inventory at fair market value. A taxpayer that is otherwise not a dealer in securities may elect to be treated as such for this purpose if the taxpayer purchases and sells debt instruments that, at the time of purchase or sale, are customer paper with respect to either the taxpayer or a corporation that is a member of the same consolidated group as the taxpayer (the ‘‘customer paper election’’). Under prior law, significant numbers of taxpayers whose principal activities are selling nonfinancial goods or providing nonfinancial services (such as retailers and utilities) were making the customer paper election as a means of restoring bad debt reserves. The customer paper election was ANALYTICAL PERSPECTIVES also being used inappropriately to mark-to-market trade receivables that bear little or no interest in order to recognize loss. Under this Act, certain trade receivables are no longer eligible for mark-to-market treatment. Specifically, generally effective for taxable years ending after July 22, 1998, sellers of nonfinancial goods and services may not mark-to-market receivables generated on the sale of goods or services sold on credit when such receivables are retained by the seller or a related person. Disregard minimum distributions in determining adjusted gross income (AGI) for conversions to a Roth Individual Retirement Account (IRA)—Under current law, uniform minimum distribution rules generally apply to all types of tax-favored retirement vehicles, including qualified retirement plans and annuities, IRAs (other than Roth IRAs), and tax-sheltered annuities. Distributions are required to begin no later than the individual’s required beginning date. In the case of an IRA, the required beginning date is April 1 of the calendar year following the calendar year in which the IRA owner attains age 701⁄2. Extensive regulations have been issued for purposes of calculating minimum distributions, which generally are includible in the taxpayer’s gross income in the year of distribution. A 50percent excise tax applies to the extent a minimum distribution is not made. Under current law, taxpayers with AGI of less than $100,000 are eligible to roll over or convert an existing IRA to a Roth IRA. Effective for taxable years beginning after December 31, 2004, minimum required distributions from IRAs will be excluded from the definition of AGI, solely for purposes of determining eligibility to convert from an IRA to a Roth IRA. As under present law, the required minimum distribution will not be eligible for conversion and will be includible in gross income. The Omnibus Consolidated and Emergency Supplemental Appropriations Act, 1999.—This Act, which was signed by President Clinton on October 21, 1998, represents a significant step forward for America, helping to protect the surplus until Social Security is reformed, forging a bipartisan agreement on funding the International Monetary Fund and putting in place critical investments in education and training. This Act also extends several business and trade tax provisions that had expired or were about to expire, provides tax breaks for farmers and ranchers, and includes several other tax changes. The major provisions of the Act affecting receipts are described below. Emergency Tax Relief for Farmers Extend permanently income-averaging for farmers.— Under prior law, effective for taxable years beginning after December 31, 1997 and before January 1, 2001, an electing individual taxpayer generally was allowed to elect to compute his or her current year regular tax liability by averaging, over the three-year period, all or a portion of his or her taxable income from farming. This Act permanently extends this provision, effec- 3. 59 FEDERAL RECEIPTS tive for taxable years beginning after December 31, 2000. Modify taxation of farm production flexibility contract payments.—A taxpayer generally is required to include an item in income no later than the time of its actual or constructive receipt, unless such amount properly is accounted for in a different period under the taxpayer’s method of accounting. If a taxpayer has an unrestricted right to demand the payment of an amount, the taxpayer is in constructive receipt of that amount whether or not the taxpayer makes the demand and actually receives the payment. Under production flexibility contracts entered into between certain eligible owners and producers and the Secretary of Agriculture (as provided in the Federal Agriculture Improvement and Reform Act of 1996), annual payments are made at specific times during the Federal government’s fiscal year. One-half of each annual payment is to be made on either December 15 or January 15 of the fiscal year, at the option of the recipient; the remaining one-half is to be paid no later than September 30 of the fiscal year. The option to receive the payment on December 15 potentially results in the constructive receipt (and thus potential inclusion in income) of one-half of the annual payment at that time, even if the option to receive the amount on January 15 is elected. For fiscal year 1999, as provided under The Emergency Farm Financial Relief Act of 1998, all payments are to be paid at such time or times during the fiscal year as the recipient may specify. This option to receive all of the 1999 payment in calendar year 1998 potentially results in constructive receipt (and thus potential inclusion in income) in that year, whether or not the amounts are actually received. Under this Act, effective for production flexibility contract payments made in taxable years ending after December 31, 1995, the time a production flexibility contract payment is to be included in income is to be determined without regard to the options granted for payment. Extend the net operating loss carryback period for farmers.—A net operating loss (NOL) is, generally, the amount by which business deductions of a taxpayer exceed business gross income. Generally, an NOL may be carried back two years and carried forward 20 years to offset taxable income in those years. One exception provides that, in the case of an NOL attributable to Presidentially declared disasters for taxpayers engaged in a farming business or a small business, the NOL can be carried back three years, as provided under prior law. Under this provision, a special five-year carryback period is provided for a farming loss, regardless of whether the loss is incurred in a Presidentially declared disaster area; the carryforward period remains at 20 years. The provision is effective for such NOLs arising in taxable years beginning after December 31, 1997. to qualifying expenditures paid or incurred during the period July 1, 1998 through June 30, 1999. Extend the work opportunity tax credit.—The work opportunity tax credit, which provides an incentive for employers to hire individuals from certain targeted groups, is extended to apply to individuals who begin work on or after July 1, 1998 and before July 1, 1999. Extend the welfare-to-work tax credit.—The welfareto-work tax credit enables employers to claim a tax credit on the first $20,000 of eligible wages paid to certain long-term family assistance recipients. This credit is extended to apply to individuals who begin work after April 30, 1999 and before July 1, 1999. Extend permanently the deduction for contributions of stock to private foundations.—The deduction for a contribution of property to a private foundation is limited to the adjusted basis of the contributed property. However, prior law allowed a taxpayer who contributed qualified appreciated stock to a private foundation before July 1, 1998 to deduct the full fair market value of the stock, rather than the adjusted basis of the contributed stock. This Act permanently extends the rule for private foundations effective for contributions of qualified appreciated stock made on or after July 1, 1998. Extend and modify exceptions provided under subpart F for certain active financing income.—Under the Subpart F rules, certain U.S. shareholders of a controlled foreign corporation (CFC) are subject to U.S. tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes ‘‘foreign personal holding company income’’ and insurance income. The U.S. 10-percent shareholders of a CFC also are subject to current inclusion with respect to their shares of the CFC’s foreign base company services income (income derived from services performed for a related person outside the country in which the CFC is organized). Under prior law, certain income derived in the active conduct of a banking, financing, insurance, or similar business (only for taxable years beginning in 1998) was excepted from the Subpart F rules regarding the taxation of foreign personal holding company income and foreign base company services income. This Act extends the exception for one year, with modifications, to apply to such income derived in taxable year 1999. Extend Generalized System of Preferences (GSP).— Under GSP, duty-free access is provided to over 4,000 items from eligible developing countries that meet certain worker rights, intellectual property protection, and other criteria. This program, which had expired after June 30, 1998, is temporarily extended through June 30, 1999. Refunds of any duty paid between June 30, 1998 and October 21, 1998 are provided upon request of the importer. Extension of Expiring Tax and Trade Provisions Extend research and experimentation tax credit.—The 20-percent tax credit for certain incremental research and experimentation expenditures is extended to apply Other Provisions Allow personal tax credits fully against regular tax liability.—Certain nonrefundable personal tax credits 60 (dependent care credit, credit for the elderly and disabled, adoption credit, child tax credit, credit for interest on certain home mortgages, HOPE Scholarship and Lifetime Learning credit, and the D.C. homebuyer’s credit) are provided under current law. Generally, these credits are allowed only to the extent that the individual’s regular income tax liability exceeds the individual’s tentative minimum tax. An additional child tax credit is provided under current law to families with three or more qualifying children. This credit, which may be offset against social security payroll tax liability (provided that liability exceeds the amount of the earned income credit), is reduced by the amount of the individual’s minimum tax liability (that is, the amount by which the individual’s tentative minimum tax exceeds the individual’s regular tax liability). For taxable year 1998, this Act allows nonrefundable personal tax credits to offset regular income tax liability in full (as opposed to only the amount by which the regular tax liability exceeds the tentative minimum tax). In addition, for taxable year 1998, the additional child credit provided to families with three or more qualifying children is not reduced by the amount of the individual’s minimum tax liability. Accelerate deduction of health insurance costs for selfemployed individuals.—Under prior law self-employed individuals were allowed a deduction for the cost of health insurance for themselves and their spouse and dependents as follows: 45 percent for 1998 and 1999; 50 percent for 2000 and 2001; 60 percent for 2002; 80 percent for 2003 through 2005; 90 percent for 2006; and 100 percent for 2007 and subsequent years. This Act increases the allowable deduction to 100 percent as follows: 60 percent for 1999 through 2001; 70 percent for 2002; and 100 percent for 2003 and subsequent years. Modify estimated tax requirements of individuals.— An individual taxpayer generally is subject to an addition to tax for any underpayment of estimated tax. An individual generally does not have an underpayment of estimated tax if timely estimated tax payments are made at least equal to: (1) 100 percent of the tax shown on the return of the individual for the preceding tax year (the ‘‘100 percent of last year’s liability safe harbor’’) or (2) 90 percent of the tax shown on the return for the current year. For any individual with an AGI of more than $150,000 as shown on the return for the preceding taxable year, the 100 percent of last year’s safe harbor generally is modified to be a 110 percent of last year’s liability safe harbor. However, under prior law, the 110 percent of last year’s liability safe harbor for individuals with AGI of more than $150,000 was modified for taxable years beginning in 1999 through 2002, as follows: for taxable years beginning in 1999, 2000, and 2001 the safe harbor is 105 percent; and for taxable years beginning in 2002, the safe harbor is 112 percent. Under this Act the estimated tax safe harbor for individuals with AGI of more than $150,000 is modified as follows: for taxable years beginning in 2000 and 2001 the safe harbor is 106 percent. ANALYTICAL PERSPECTIVES Increase State volume limits on private activity taxexempt bonds.—Interest on bonds issued by States and local governments to finance activities carried out and paid for by private persons (private activity bonds) is taxable unless the activities are specified in the Internal Revenue Code. The volume of tax-exempt private activity bonds that State and local governments may issue in each calendar year is limited by State-wide volume limits. Under prior law, the annual volume limit for any State was equal to the greater of $50 per resident of the State or $150 million. Under this Act the annual private activity bond volume limit is increased to the greater of $75 per resident or $225 million for 2007 and subsequent years. The increase is phased-in annually, beginning in 2003, as follows: for 2003, the greater of $55 per resident or $165 million; for 2004, the greater of $60 per resident or $180 million; for 2005, the greater of $65 per resident or $195 million; and for 2006, the greater of $70 per resident or $210 million. Allow States a limited period of time to exempt student employees from social security.—The Social Security Amendments of 1972 provided an opportunity for States to obtain exemptions from social security coverage for student employees of public schools, colleges, and universities. Three States chose not to seek an exemption from social security coverage for these employees. Under this Act States are allowed a limited window of time (January 1 through March 31, 1999), to modify existing State agreements to exempt such students from social security coverage effective with respect to wages earned after June 30, 2000. Revenue Offset Provisions Modify treatment of certain deductible liquidating distributions of real estate investment trusts (REITs) and regulated investment companies (RICs).—REITs and RICs are allowed a deduction for dividends paid to their shareholders. The deduction for dividends paid includes amounts distributed in liquidation that are properly chargeable to earnings and profits. In addition, in the case of a complete liquidation occurring within 24 months after the adoption of a plan of complete liquidation, any distribution made pursuant to such plan is deductible to the extent of earnings and profits. Rules that govern the receipt of dividends from REITs and RICs generally provide for including the amount of the dividend in the income of the shareholder receiving the dividend that was deducted by the REIT or RIC. However, in the case of a liquidating distribution by a REIT or RIC to a corporation owning at least 80 percent of its stock, a separate rule under prior law generally provided that the distribution was tax-free to the parent corporation. As a result, a liquidating REIT or RIC was able to deduct amounts paid to its parent corporation without the parent corporation including corresponding amounts in its income. Effective for distributions on or after May 22, 1998 (regardless of when the plan of liquidation was adopted), any amount that a liquidating REIT or RIC takes as a deduction for 3. 61 FEDERAL RECEIPTS dividends paid with respect to an 80-percent corporate owner is includible in the income of the recipient corporation. As under prior law, the liquidating corporation may designate the amount distributed as a capital gain dividend or, in the case of a RIC, a dividend eligible for the 70-percent dividends-received deduction or an exempt interest dividend. Expand list of taxable vaccines.—Under prior law an excise tax of $.75 per dose is levied on the following vaccines: diphtheria, pertussis, tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, and varicella (chickenpox). This Act adds any vaccine against rotavirus gastroenteritis to the list of taxable vaccines, effective for vaccines sold by a manufacturer or importer after October 21, 1998. Clarify and expand math error procedures.—If the IRS determines that a taxpayer has failed to provide a correct taxpayer identification number (TIN) that is required by statute, the IRS may, in certain cases, use the streamlined procedures for mathematical and clerical errors (‘‘math error procedures’’) to expedite the assessment of tax. This Act provides the following clarifications to the math error procedures applicable to the child tax credit, the child and dependent care tax credit, the personal exemption for dependents, the Hope and Lifetime Learning tax credits, and the earned income tax credit. First, the term ‘‘correct TIN’’ used on a tax return is defined as the TIN assigned to such individual by the Social Security Administration (SSA), or in certain limited cases, the IRS. Second, the IRS is authorized to use data obtained from SSA to verify that the TIN provided on the return corresponds to the individual for whom the TIN was assigned. Such data include the individual’s name, age or date of birth, and Social Security number. Third, the IRS is authorized to use math error procedures to deny eligibility for those tax benefits that impose a statutory age restriction (i.e., the child tax credit, the child and dependent care tax credit and the earned income tax credit) if the taxpayer provides a TIN that the IRS determines, using data from SSA, does not meet the statutory age restrictions. These changes are effective for taxable years ending after October 21, 1998. Restrict special net operating loss carryback rules for specified liability losses.— The portion of a net operating loss that qualifies as a specified liability loss may be carried back 10 years rather than being limited to the general two-year carryback period. A specified liability loss includes amounts allowable as a deduction with respect to product liability, and also certain liabilities that arise under Federal or State law or out of any tort of the taxpayer. The proper interpretation of the specified liability loss provisions as they apply to liabilities arising under Federal or State law or out of any tort of the taxpayer has been the subject of manipulation and significant controversy. This Act modifies the specified liability loss provisions to provide that only a limited class of liabilities qualifies as a specified liability loss. Effective for liability losses arising in taxable years ending after October 21, 1998, specified liability losses include (in addition to product liability losses) any amount allowable as a deduction that is attributable to a liability under Federal or State law for reclamation of land, decommissioning of a nuclear power plant (or any unit thereof), dismantlement of an offshore oil drilling platform, remediation of environmental contamination, or payments under a workers’ compensation statute. Modify taxation of prizes and awards.—A taxpayer generally is required to include an item in income no later than the time of its actual or constructive receipt, unless the item properly is accounted for in a different period under the taxpayer’s method of accounting. If a taxpayer has an unrestricted right to demand the payment of an amount, the taxpayer is in constructive receipt of that amount whether or not the taxpayer makes the demand and actually receives the payment. Under prior law, the winner of a contest who was given the option of receiving either a lump-sum distribution or an annuity was considered to be in constructive receipt of the award on becoming entitled to the award, and was required to include the value of the award in gross income, even if the annuity option was exercised. Under this Act the existence of a ‘‘qualified prize option’’ is disregarded in determining the taxable year for which any portion of a qualified prize is to be included in income. A qualified prize option is an option that entitles a person to receive a single cash payment in lieu of a qualified prize (or portion thereof), provided such option is exercisable not later than 60 days after the prize winner becomes entitled to the prize. Thus, a qualified prize winner who is provided the option to choose either cash or an annuity is not required to include amounts in gross income immediately if the annuity option is exercised. This change applies to any qualified prize to which a person first becomes entitled after October 21, 1998. In order to give previous prize winners a one-time option to alter previous payment arrangements, the change also applies to any qualifed prize to which a person became entitled on or before October 21, 1998 if the person has an option to receive a lump-sum cash payment only during some portion of the 18-month period beginning on July 1, 1999. ADMINISTRATION PROPOSALS The President’s plan targets tax relief to provide child-care assistance to working families and support to Americans with long-term care needs. The President’s plan also provides several incentives to promote education, including a school construction and mod- ernization proposal. In addition, the President’s plan includes initiatives to promote energy efficiency and environmental objectives and incentives to promote retirement savings, as well as extensions of certain expiring tax provisions. 62 ANALYTICAL PERSPECTIVES Make Health Care More Affordable Provide tax relief for long-term care needs.—Current law provides a tax deduction for certain long-term care expenses. However, the deduction does not assist with all long-term care expenses, especially the costs of informal family caregiving. The Administration proposes to provide a new long-term care tax credit of $1,000. The credit could be claimed by a taxpayer for himself or herself or for a spouse or dependent with long-term care needs. To qualify for the credit, an individual with long-term care needs must be certified by a licensed physician as being unable for at least six months to perform at least three activities of daily living without substantial assistance from another individual due to loss of functional capacity. An individual may also qualify if he or she requires substantial supervision to be protected from threats to his or her own health and safety due to severe cognitive impairment and has difficulty with one or more activities of daily living or certain other age-appropriate activities. For purposes of the proposed credit, the current-law dependency tests would be liberalized, raising the gross income limit and allowing taxpayers to use a residency test rather than a support test. The credit would be phased out—in combination with the child credit and the disabled worker credit—for taxpayers with adjusted gross income (AGI) in excess of the following thresholds: $110,000 for married taxpayers filing a joint return, $75,000 for a single taxpayer or head of household, and $55,000 for married taxpayers filing a separate return. The proposal would be effective for taxable years beginning after December 31, 1999. Provide tax relief for workers with disabilities.— Under current law, disabled taxpayers may claim an itemized deduction for impairment-related work expenses. The Administration proposes to allow disabled workers to claim a $1,000 credit. This credit would help compensate people with disabilities for both formal and informal costs associated with work (e.g., personal assistance to get ready for work or special transportation). In order to be considered a worker with disabilities, a taxpayer must submit a licensed physician’s certification that the taxpayer has been unable for at least 12 months to perform at least one activity of daily living without substantial assistance from another individual. A severely disabled worker could potentially qualify for both the long-term care and disabled workers tax credits. The credit would be phased out—in combination with the child credit and the disabled worker credit—for taxpayers with adjusted gross income (AGI) in excess of the following thresholds: $110,000 for married taxpayers filing a joint return, $75,000 for a single taxpayer or head of household, and $55,000 for married taxpayers filing a separate return. The proposal would be effective for taxable years beginning after December 31, 1999. Provide tax relief to encourage small business health plans.—Small businesses generally face higher costs than do larger employers in setting up and operating health plans in the current insurance market. Health benefit purchasing coalitions provide an opportunity for small businesses to purchase health insurance for their workers at reduced cost and to offer a greater choice of health plans. However, the formation of health benefit purchasing coalitions has been hindered by their limited access to capital. To facilitate the formation of these coalitions, the Administration proposes to establish a temporary, special rule that would facilitate private foundation grants and loans to fund the initial operating expenses of qualified health benefit purchasing coalitions (i.e., those certified by a Federal or State agency as meeting specified criteria) by treating such grants and loans as made for exclusively charitable purposes. In addition, to encourage use of qualified health benefit purchasing coalitions by small businesses, the Administration proposes a temporary tax credit for qualifying small employers that currently do not provide health insurance to their workforces. The credit would be equal to 10 percent of employer contributions to employee health plans purchased through a qualified coalition. The maximum credit amount would be $200 per year for individual coverage and $500 per year for family coverage (to be reduced proportionately if coverage is provided for less than 12 months during the employer’s taxable year). The credit would be allowed to a qualifying small employer only with respect to contributions made during the first 24 months that the employer purchases health insurance through a qualified coalition, and would be subject to the overall limitations of the general business credit. The proposal would be effective for taxable years beginning after December 31, 1999, for health plans established before January 1, 2004. The special foundation rule would apply to grants and loans made prior to January 1, 2004 for initial operating expenses incurred prior to January 1, 2006. Expand Education Initiatives Provide incentives for public school construction and modernization.—The Taxpayer Relief Act of 1997 enacted a provision that allows certain public schools to issue ‘‘qualified zone academy bonds,’’ the interest on which is effectively paid by the Federal government in the form of an annual income tax credit. The proceeds of the bonds can be used for a number of purposes, including teacher training, purchases of equipment, curricular development, and rehabilitation and repair of the school facilities. The Administration proposes to institute a new program of Federal tax assistance for public elementary and secondary school construction and modernization. Under the proposal, State and local governments (including U.S. possessions) would be able to issue up to $22 billion of ‘‘qualified school modernization bonds’’ ($11 billion in each of 2000 and 2001). In addition, $400 million of bonds ($200 million in each of 2000 and 2001) would be allocated for the construction and renovation of Bureau of Indian Affairs funded schools. Holders of these bonds would 3. FEDERAL RECEIPTS receive annual Federal income tax credits, set according to market interest rates by the Treasury Department, in lieu of interest. Issuers would be responsible for repayment of principal. At least 95 percent of the bond proceeds of a qualified school modernization bond must be used to finance public school construction or rehabilitation. The Administration also proposes to authorize the issuance of additional qualified zone academy bonds in 2000 and 2001 of $1.0 billion and $1.4 billion, respectively, and to allow the proceeds of these bonds to be used for school construction. Extend employer-provided educational assistance and include graduate education.—Certain amounts paid by an employer for educational assistance provided to an employee currently are excluded from the employee’s gross income for income and payroll tax purposes. The exclusion is limited to $5,250 of educational assistance with respect to an individual during a calendar year and applies whether or not the education is job-related. The exclusion currently is limited to undergraduate courses beginning before June 1, 2000. The Administration proposes to extend the current law exclusion for eighteen months to apply to undergraduate courses beginning before January 1, 2002. In addition, the exclusion would be expanded to cover graduate expenses beginning after June 30, 1999 and before January 1, 2002. Provide tax credit for workplace literacy and basic education programs.—Given the increased reliance on technology in the workplace, workers with low levels of education face greater risk of unemployment than their more educated coworkers. Although the costs of providing workplace literacy and basic education programs to employees are generally deductible to employers under current law, no tax credits are allowed for any employer-provided education. As a result, employers lack sufficient incentive to provide basic education and literacy programs, the benefits of which are more difficult for employers to capture through increased productivity than the benefits of job-specific education. The Administration proposes to allow employers who provide certain workplace literacy, English literacy, or basic education programs for their eligible employees to claim a credit against Federal income taxes equal to 10 percent of the employer’s qualified expenses, up to a maximum credit of $525 per participating employee. Qualified education would be limited to basic instruction at or below the level of a high school degree and to English literacy instruction. Eligible employees in basic education programs generally would not have received a high school degree or its equivalent. Instruction would be provided either by the employer, with curriculum approved by the State adult education authority, or by local education agencies or other providers certified by the Department of Education. The credit would be available for taxable years beginning after December 31, 1999. 63 Encourage sponsorship of qualified zone academies.—Under current law, State and local governments can issue qualified zone academy bonds to fund improvements in certain ‘‘qualified zone academies’’ which provide elementary or secondary education. To encourage corporations to become sponsors of such academies, a credit against Federal income tax would be provided equal to 50 percent of the amount of corporate sponsorship payments made to a qualified zone academy located in (or adjacent to) a designated empowerment zone or enterprise community. The credit would be available only if a credit allocation has been made with respect to the corporate sponsorship payment by the local governmental agency with responsibility for implementing the strategic plan of the empowerment zone or enterprise community. Up to $4 million of credits could be allocated with respect to each of the 31 designed empowerment zones; and up to $1 million of credits could be allocated with respect to each of the 95 designated enterprise communities. The credit would be subject to present law general business credit rules, and would be effective for sponsorship payments made after December 31, 1999. Eliminate 60-month limit on student loan interest deduction.—Current law provides an income tax deduction for certain interest paid on a qualified education loan during the first 60 months that interest payments are required, effective for interest due and paid after December 31, 1997. The maximum deduction available is $2,500 for years after 2000 (for years 1998, 1999 and 2000, the limits are $1,000, $1,500 and $2,000, respectively) and the deduction is phased-out for taxpayers with adjusted gross income between $40,000 and $55,000 (between $60,000 and $75,000 for joint filers). The 60-month limitation under current law adds significant complexity and administrative burdens for taxpayers, lenders, loan servicing agencies, and the IRS. Thus, to simplify the calculation of deductible interest payments, reduce administrative burdens, and provide longer-term relief to low-and middle-income taxpayers with large educational debt, the Administration proposes to eliminate the 60-month limitation. This proposal would be effective for interest due and paid on qualified education loans after December 31, 1999. Eliminate tax when forgiving student loans subject to income contingent repayment.—Students who borrow money to pay for postsecondary education through the Federal government’s direct loan program may elect income contingent repayment of the loan. If they elect this option, their loan repayments are adjusted in accordance with their income. If after the borrower makes repayments for a twenty-five year period any loan balance remains, it is forgiven. The Administration proposes to eliminate any Federal income tax the borrower may otherwise owe as a result of the forgiveness of the loan balance. The proposal would be effective for loan cancellations after December 31, 1999. 64 ANALYTICAL PERSPECTIVES Provide tax relief for participants in certain Federal education programs.—Present law provides tax-free treatment for certain scholarship and fellowship grants used to pay qualified tuition and related expenses, but not to the extent that any grant represents compensation for services. In addition, tax-free treatment is provided for certain discharges of student loans on condition that the individual works for a certain period of time in certain professions for any of a broad class of employers. To extend tax-free treatment to education awards under certain Federal programs, the Administration proposes to amend current law to provide that any amounts received by an individual under the National Health Service Corps (NHSC) Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assistance Program are ‘‘qualified scholarships’’ excludable from income, without regard to the recipient’s future service obligation. In addition, the proposal also would provide an exclusion from income for any repayment or cancellation of a student loan under the NHSC Scholarship Program, the Americorps Education Award Program, or the Armed Forces Health Professions Loan Repayment Program. The exclusion would apply only to the extent that the student incurred qualified tuition and related expenses for which no education credit was claimed during academic periods when the student loans were incurred. The proposals would be effective for awards received after December 31, 1999. Make Child Care More Affordable Increase, expand, and simplify child and dependent care tax credit.—Under current law, taxpayers may receive a nonrefundable tax credit for a percentage of certain child care expenses they pay in order to work. The credit rate is phased down from 30 percent of expenses (for taxpayers with adjusted gross incomes of $10,000 or less) to 20 percent (for taxpayers with adjusted gross incomes above $28,000). The Administration believes that the maximum credit rate is too low. Moreover, because it phases down at a very low threshold of adjusted gross income, many families who have significant child care costs and relatively low incomes are not eligible for the maximum credit. To alleviate the burden of child care costs for these families, the Administration proposes to increase the maximum credit rate from 30 percent to 50 percent and to extend eligibility for the maximum credit rate to taxpayers with adjusted gross incomes of $30,000 or less. The credit rate would be phased down gradually for taxpayers with adjusted gross incomes between $30,000 and $59,000. The credit rate would be 20 percent for taxpayers with adjusted gross incomes over $59,000. Under current law, no additional tax assistance under the child and dependent care tax credit is provided to families with infants, who require intense and sustained care. Furthermore, parents who themselves care for their infants, instead of incurring out-of-pocket child care expenses, receive no benefit under the child and dependent care tax credit. In order to provide assistance to these families, the Administration proposes to supplement the credit for all taxpayers with children under the age of one, whether or not they incur outof-pocket child care expenses. The amount of additional credit would be the applicable credit rate multiplied by $500 for a child under the age of one ($1,000 for two or more children under the age of one). The Administration also proposes to simplify eligibility for the credit by eliminating a complicated household maintenance test. Certain credit parameters would be indexed. The proposal would be effective for taxable years beginning after December 31, 1999. Provide tax incentives for employer-provided child-care facilities.—The Administration proposes to provide taxpayers a credit equal to 25 percent of expenses incurred to build or acquire a child care facility for employee use, or to provide child care services to children of employees directly or through a third party. Taxpayers also would be entitled to a credit equal to 10 percent of expenses incurred to provide employees with child care resource and referral services. A taxpayer’s credit could not exceed $150,000 in a single year. Any deduction the taxpayer would otherwise be entitled to take for the expenses would be reduced by the amount of the credit. Similarly, the taxpayer’s basis in a facility would be reduced to the extent that a credit is claimed for expenses of constructing or acquiring the facility. The credit would be effective for taxable years beginning after December 31, 1999. Provide Incentives to Revitalize Communities Increase low-income housing tax credit per capita cap to $1.75.—Low-income housing tax credits provide an incentive to build and make available affordable rental housing units to households with low incomes. The amount of first-year credits that can be awarded in each State is currently limited to $1.25 per capita. That limit has been unchanged since it was established in 1986. The Administration proposes to increase the annual State housing credit limitation to $1.75 per capita effective for calendar years beginning after 1999. The proposed increase in this cap will permit additional new and rehabilitated low-income housing to be provided while still encouraging State housing agencies to award the credits to projects that meet specific needs. Provide Better America Bonds to improve the environment.—Under current law, State and local governments may issue tax-exempt bonds to finance purely public environmental projects. Certain other environmental projects may also be financed with tax-exempt bonds, but are subject to an overall cap on privatepurpose tax-exempt bonds. The subsidy provided with tax-exempt bonds may not provide a deep enough subsidy to induce State and local governments to undertake beneficial environmental infrastructure projects. The Administration proposes to allow State and local 3. 65 FEDERAL RECEIPTS governments (including U.S. possessions and Native American tribal governments) to issue tax credit bonds (similar to existing Qualified Zone Academy Bonds) to finance projects to protect open spaces or to otherwise improve the environment. Significant public benefits would be provided by creating more livable urban and rural environments; creating forest preserves near urban areas; protecting water quality; rehabilitating land that has been degraded by toxic or other wastes or destruction of its ground cover; and improving parks and reestablishing wetlands. The Environmental Protection Agency will allocate $1.9 billion in annual bond authority for five years starting in 2000 based on competitive applications. The bonds would have a maximum maturity of 15 years and the bond issuer effectively would receive an interest-free loan for the term of the bonds. During that interval, bond holders receive Federal income tax credits in lieu of interest. the corporate or shareholder level, but the partnership would remain subject to an entity-level tax upon ceasing activity as a SSBIC or at any time that it disposes of assets that it holds at the time of conversion on the amount of ‘‘built-in’’ gains inherent in such assets at the time of conversion. Third, the proposal would make it easier for a SSBIC to meet the qualifying income, distribution of income, and diversification of assets tests to qualify as a tax-favored regulated investment company. Finally, in the case of a direct or indirect sale of SSBIC stock that qualifies for treatment under section 1202, the proposal would raise the exclusion of gain from 50 percent to 60 percent. The taxfree rollover and section 1202 provisions would be effective for sales occurring after the date of enactment. The regulated investment company provisions would be effective for taxable years beginning on or after the date of enactment. Provide New Markets Tax Credit.—Businesses located in low-income urban and rural communities often lack access to sufficient equity capital. To help attract new capital to these businesses, taxpayers would be allowed a credit against Federal income taxes for certain investments made to acquire stock or other equity interests in a community development investment entity selected by the Treasury Department to receive a credit allocation. Selected community development investment entities generally would be required to use the investment proceeds to provide capital to businesses located in low-income communities. During the period 2000–2004, the Treasury Department would authorize selected community development investment entities to issue $6 billion of new stock or equity interests with respect to which credits could be claimed. The credit would be allowed for each year during the five-year period after the stock or equity interest is acquired from the selected community development investment entity, and the credit amount that could be claimed for each of the five years would equal six percent of the amount paid to acquire the stock or equity interest from the community development investment entity. The credit would be subject to current-law general business credit rules, and would be available for qualified investments made after December 31, 1999. Extend wage credit for two new Empowerment Zones (EZs).—OBRA 93 authorized a Federal demonstration project in which nine EZs and 95 empowerment communities would be designated in a competitive application process. Among other benefits, businesses located in the nine original EZs are eligible for three Federal tax incentives: an employment and training credit; an additional $20,000 per year of section 179 expensing; and a new category of tax-exempt private activity bonds. The Taxpayer Relief Act of 1997 authorized the designation of two additional EZs located in urban areas, which generally are eligible for the same tax incentives as are available within the EZs authorized by OBRA 93. The two additional EZs were designated in early 1998, but the tax incentives provided for them do not take effect until January 1, 2000. The incentives generally remain in effect for 10 years. The wage credit, however, is phased down beginning in 2005 and expires after 2007. The Administration proposes that the wage credit for the two additional EZs would remain in effect until January 1, 2010, and would be phased down using the same percentages that apply to the original empowerment zones designated under OBRA 93. Expand tax incentives for specialized small business investment companies (SSBICs).— Current law provides certain tax incentives for investment in SSBICs. The Administration proposes to enhance the tax incentives for SSBICs. First, the existing provision allowing a tax-free rollover of the proceeds of a sale of publicly-traded securities into an investment in a SSBIC would be modified to extend the rollover period to 180 days, to allow investment in the preferred stock of a SSBIC, to eliminate the annual caps on the SSBIC rollover gain exclusion, and to increase the lifetime caps to $750,000 per individual and $2,000,000 per corporation. Second, the proposal would allow a SSBIC to convert from a corporation to a partnership within 180 days of enactment without giving rise to tax at either Buildings Promote Energy Efficiency and Improve the Environment Provide tax credit for energy-efficient building equipment.—No income tax credit is provided currently for investment in energy-efficient building equipment. The Administration proposes to provide a new tax credit for the purchase of certain highly efficient building equipment technologies including fuel cells, electric heat pump water heaters, natural gas heat pumps, residential size electric heat pumps, natural gas water heaters, and advanced central air conditioners. The credit would equal 10 or 20 percent of the amount of qualified investment depending upon the energy efficiency of the qualified item, subject to a cap. The 10percent credit generally would be available for equip- 66 ANALYTICAL PERSPECTIVES ment purchased during the two-year period beginning January 1, 2000 and ending December 31, 2001. The 20-percent credit would be available for equipment purchased during the four-year period beginning January 1, 2000 and ending December 31, 2003. Provide tax credit for new energy-efficient homes.—No income tax credit is provided currently for investment in energy-efficient homes. The Administration proposes to provide a tax credit to taxpayers who purchase, as a principal residence, certain newly constructed homes that are highly energy efficient. The credit would equal $1,000, $1,500 or $2,000 depending upon the home’s energy efficiency. The $1,000 credit would be available for homes purchased between January 1, 2000 and December 31, 2001 that are at least 30 percent more energy efficient than the standard under the 1998 International Energy Conservation Code (IECC). The $1,500 credit would be available for homes purchased between January 1, 2000 and December 31, 2002 that are at least 40 percent more energy efficient than the IECC standard. The $2,000 credit would be available for homes purchased between January 1, 2000 and December 31, 2004 that are at least 50 percent more energy efficient than the IECC standard. Transportation Extend the electric vehicle tax credit; provide tax credit for fuel-efficient vehicles.—Under current law, a 10-percent tax credit up to $4,000 is provided for the cost of a qualified electric vehicle. The full amount of the credit is available for purchases prior to 2002. The credit begins to phase down in 2002 and is not available after 2004. The Administration proposes to extend the present $4,000 credit through 2006 and to allow the full amount of the credit to be available for qualified electric vehicles through 2006. The Administration also proposes to provide a tax credit for the purchase of certain fuel-efficient hybrid vehicles. The credit would be: (a) $1,000 for each vehicle that is one-third more fuel efficient than a comparable vehicle in its class, effective for purchases of qualifying vehicles after December 31, 2002 and before January 1, 2005; (b) $2,000 for each vehicle that is two-thirds more fuel efficient than a comparable vehicle in its class, effective for purchases of qualifying vehicles after December 31, 2002 and before January 1, 2007; (c) $3,000 for each vehicle that is twice as fuel efficient as a comparable vehicle in its class, effective for purchases of qualifying vehicles after December 31, 2003 and before January 1, 2007; and (d) $4,000 for each vehicle that is three times as fuel efficient as a comparable vehicle in its class, effective for purchases of qualifying vehicles after December 31, 2003 and before January 1, 2007. Industry Provide investment tax credit for combined heat and power (CHP) systems.—Combined heat and power (CHP) assets are used to produce electricity (and/ or mechanical power) and usable heat from the same primary energy source. No tax credits are currently available for investment in CHP property. The Administration proposes to establish an eight-percent investment credit for qualifying CHP systems in order to encourage more efficient energy usage. The credit would apply to property placed in service in the United States after December 31, 1999 and before January 1, 2003. Renewables Provide tax credit for rooftop solar systems.— Current law provides a 10-percent business energy investment tax credit for qualifying equipment that uses solar energy to generate electricity, to heat or cool, to provide hot water for use in a structure, or to provide solar process heat. The Administration proposes a new tax credit for purchasers of roof-top photovoltaic systems and solar water heating systems located on or adjacent to the building for uses other than heating swimming pools. (Taxpayers would have to choose between the proposed credit and the current-law tax credit for each investment.) The proposed credit would be equal to 15 percent of qualified investment up to a maximum of $1,000 for solar water heating systems and $2,000 for rooftop photovoltaic systems. It would apply only to equipment placed in service after December 31, 1999 and before January 1, 2005 for solar water heating systems and after December 31, 1999 and before January 1, 2007 for rooftop photovoltaic systems. Extend wind and biomass tax credit and expand eligible biomass sources.—Current law provides taxpayers a 1.5-cent-per-kilowatt-hour tax credit, adjusted for inflation after 1992, for electricity produced from wind or ‘‘closed-loop’’ biomass. The electricity must be sold to an unrelated third party and the credit applies to the first 10 years of production. The current credit applies only to facilities placed in service before July 1, 1999, after which it expires. The Administration proposes to extend the current credit for five years, to facilities placed in service before July 1, 2004 and to expand eligible biomass to include certain biomass from forest-related resources, and agricultural and other sources. A 1.0 cent-per-kilowatt-hour tax credit would also be allowed for cofiring biomass in coal plants. Promote Expanded Retirement Savings, Security, and Portability Building on recent legislation, the Administration proposes further expansions of retirement savings incentives, including initiatives that would expand the availability of retirement plans and other workplacebased savings opportunities, particularly for moderateand lower-income workers not currently covered by employer-sponsored plans. Other proposals are designed to expand pension coverage for employees of small businesses, a group that currently has low pension coverage. The Administration also seeks to improve existing retirement plans for employers of all sizes by in- 3. FEDERAL RECEIPTS creasing retirement security for women, expanding workers’ and spouses’ rights to know about their retirement benefits, and simplifying the pension rules. Finally, the Administration proposes to increase the portability of pension coverage, which will enhance retirement savings opportunities when employees change jobs. These provisions generally are effective beginning in 2000, except as provided below. Promote Individual Retirement Account (IRA) contributions through payroll deduction.—Employers could offer employees the opportunity to make IRA contributions on a pre-tax basis through payroll deduction. Providing employees an exclusion from income (in lieu of a deduction) is designed to increase savings among workers in businesses that do not offer a retirement plan. Signing up for payroll deduction is easy for an employee. In addition, saving is facilitated because it becomes automatic as salary reduction contributions continue for each paycheck after an employee’s initial election. Peer-group participation may also encourage employees to save more. Finally, the favorable tax treatment of payroll deductions would encourage participation. Provide small business tax credit for new plans.—Effective in the year of enactment, the Administration proposes a new three-year tax credit for the administrative and retirement-education expenses of any small business that sets up a new qualified defined benefit or defined contribution plan (including a 401(k) plan), savings incentive match plan for employees (SIMPLE), simplified employee pension (SEP), or payroll deduction IRA. The credit would cover 50 percent of the first $2,000 in administrative and retirement-education expenses for the plan or arrangement for the first year of the plan and 50 percent of the first $1,000 of such expenses for each of the second and third years. The tax credit would help promote new plan sponsorship by targeting a tax benefit to employers adopting new plans or payroll deduction IRAs. Create simplified pension plan for small business.—The Administration is proposing a new small business defined benefit-type plan that combines certain key features of defined benefit plans and defined contribution plans: guaranteed minimum retirement benefits, an option for payments over the course of an employee’s retirement years, and Pension Benefit Guaranty Corporation insurance at a reduced premium, together with individual account balances that can benefit from favorable investment returns and have enhanced portability. Provide faster vesting of employer matching contributions.—The Administration is also proposing accelerated vesting of employer matching contributions under 401(k) plans (and other qualified plans). This would increase pension portability, which is important given the mobility of today’s workforce, particularly of working women. Matching contributions would be re- 67 quired to be fully vested after an employee has completed three years of service (or would vest in annual 20-percent increments beginning after two years of service). Count Family and Medical Leave Act leave for vesting and eligibility purposes.—Under the Family and Medical Leave Act (FMLA), eligible workers are entitled to up to 12 weeks of unpaid leave to care for a new child, to care for a family member who has a serious health condition, or because the worker has a serious health condition. Under the Administration’s proposal, workers who take time off under the FMLA could count that time toward retirement plan vesting and eligibility to participate. This would ensure that workers do not lose retirement benefits they have earned because they take time off under FMLA. Require joint and 75-percent annuity option for pension plans.—Current law requires certain pension plans to offer to pay pension benefits as a joint and survivor annuity; frequently, the benefit for the employee’s surviving spouse is reduced to 50 percent of the monthly benefit paid when both spouses were alive. Under the proposal, plans that are subject to the joint and survivor annuity rules would be required to offer an option that pays a survivor benefit equal to at least 75 percent of the benefit the couple received while both were alive. This option would be especially helpful to women because they tend to live longer than men and because many aged widows have incomes below the poverty level. Improve disclosure; simplify pensions.—The Administration proposes to enhance workers’ and spouses’ rights to know about their pension benefits by, among other things, requiring that the same explanation of a pension plan’s survivor benefits that is provided to a participant be provided to the participant’s spouse, and that participants in 401(k) safe harbor plans receive adequate notification and have timely election periods of plan rules governing contributions and employer matching. Improved benefits for nonhighly compensated employees under the 401(k) safe harbors, a simplified definition of highly compensated employee, and simplification of rules for multiemployer plans are also being proposed. Allow immediate participation in the Thrift Savings Plan (TSP) by new Federal employees.—Current law requires a newly-hired Federal employee to wait six to twelve months after being hired before contributing to the TSP. Rehired employees wait up to six months. Under the Administration’s proposal, all waiting periods for employee elective contributions to the TSP would be eliminated for new hires and rehires. Allow rollovers from private plans to TSP.—Current law limits employee contributions to a TSP account to salary reduction amounts, as opposed to rollover contributions from a qualified trust. The Administration 68 proposes to allow an employee to roll over an ‘‘eligible rollover distribution’’ from a qualified trust sponsored by a previous employer to the employee’s TSP account. Allow rollovers between qualified retirement plans and 403(b) tax-sheltered annuities.—Under current law, rollovers are not allowed between qualified retirement plans and section 403(b) tax-sheltered annuities. The Administration proposes that eligible rollover distributions from a qualified retirement plan could be rolled over to a section 403(b) tax-sheltered annuity and vice versa. Allow rollovers from regular IRAs to qualified plans or 403(b) tax-sheltered annuities.—The Administration’s proposal would allow individuals to consolidate their IRA funds and their workplace retirement savings in a single place. Under current law, individuals may roll over only amounts in ‘‘conduit’’ IRAs (IRAs containing only amounts rolled over from workplace retirement plans) to their qualified retirement plans or section 403(b) tax-sheltered annuities. Under the Administration’s proposal, individuals who have IRAs with deductible IRA contributions will be offered the opportunity to transfer funds from their IRAs into their qualified defined contribution retirement plan or 403(b) tax-sheltered annuity—provided that the retirement plan trustee meets the same standards as an IRA trustee. Allow rollovers of after-tax contributions.—While pre-tax contributions to retirement plans are perhaps the most common form of employee contribution, some plans also allow participants to make after-tax contributions. Under current law, these after-tax contributions cannot be rolled over when employees switch jobs. The proposal would allow individuals to roll over their after-tax contributions to their new employer’s defined contribution plan or to an IRA if the plan or IRA provider agrees to track and report the after-tax portion of the rollover for the individual. ANALYTICAL PERSPECTIVES district and earn a pension reflecting a full career of employment in the State in which they conclude their career. Under current law, these employees cannot make a tax-free transfer of the money they have saved in their 403(b) plan or governmental section 457 plan to purchase these credits and often lack other resources to use for this purpose. Under the proposal, State and local government employees will be able to use funds from these retirement savings plans to purchase service credits on a tax-free basis, i.e., through a direct transfer without first having to take a taxable distribution of these amounts. Extend Expiring Provisions Allow personal tax credits against the alternative minimum tax (AMT).—The Administration is concerned that the individual alternative minimum tax (AMT) may impose financial and compliance burdens upon taxpayers that have few tax preference items and were not the originally intended targets of the AMT. In particular, the Administration is concerned that the individual AMT may act to erode the benefits of nonrefundable tax credits (such as the education credits, the child credit, adoption credit, and the child and dependent care credit) that are intended to provide tax relief for middle-income taxpayers. In response, the Administration proposes to extend, for two years, the provision enacted in 1998 that allows an individual to offset his or her regular tax liability by nonrefundable tax credits regardless of the amount of the individual’s tentative minimum tax. The Administration hopes to work with Congress to develop a longer-term solution to the individual AMT problem. Allow rollovers of contributions from governmental 457 plans to an IRA.—Generally, amounts held under qualified retirement plans or section 403(b) tax-sheltered annuities plans may be rolled over to an IRA. However, under current law, amounts held under nonqualified deferred compensation plans of State or local governments (governmental section 457 plans) may not be rolled over into an IRA and are taxable upon distribution. The Administration’s proposal would allow individuals to roll over the money they have saved in a governmental section 457 plan to an IRA. Extend the work opportunity tax credit.—The work opportunity tax credit provides an incentive for employers to hire individuals from certain targeted groups. The credit equals a percentage of qualified wages paid during the first year of the individual’s employment with the employer. The credit percentage is 25 percent for employment of at least 120 hours but less than 400 hours and 40 percent for employment of 400 or more hours. The credit expires with respect to employees who begin work after June 30, 1999. The Administration proposes to extend the work opportunity tax credit so that the credit would be effective for individuals who begin work before July 1, 2000. The proposal also clarifies the interaction of the work opportunity tax credit and the welfare-to-work tax credit. This proposed clarification would be effective for taxable years beginning on or after the date of first committee action. Facilitate the purchase of service credits in governmental defined benefit plans.—Employees of State and local governments, particularly teachers, often move between States and school districts in the course of their careers. Under State law, they often can purchase service credits in their State defined benefit pension plans for time spent in another State or Extend the welfare-to-work tax credit.—The welfare-to-work tax credit enables employers to claim a tax credit on the first $20,000 of eligible wages paid to certain long-term family assistance recipients. The credit is 35 percent of the first $10,000 of eligible wages in the first year of employment and 50 percent of the first $10,000 of eligible wages in the second year of 3. FEDERAL RECEIPTS employment. The credit is effective for individuals who begin work before July 1, 1999. The Administration proposes to extend the welfare-to-work tax credit for one year, so that the credit would be effective for individuals who begin work before July 1, 2000. Extend the R&E tax credit.—The Administration proposes to extend the tax credit provided for certain research and experimentation expenditures, which is scheduled to expire after June 30, 1999, for one year through June 30, 2000. Make permanent the expensing of brownfields remediation costs.—Under the Taxpayer Relief Act of 1997, taxpayers can elect to treat certain environmental remediation expenditures that would otherwise be chargeable to capital account as deductible in the year paid or incurred. The provision does not apply to expenditures paid or incurred after December 31, 2000. The Administration proposes that the provision be made permanent. Extend tax credit for first-time D.C. homebuyers.—The Administration proposes to extend the tax credit provided for the first-time purchase of a principal residence in the District of Columbia, which is scheduled to expire after December 31, 2000, for one year through December 31, 2001. Simplify The Tax Laws Provide optional Self-employment Contributions Act (SECA) computations.—Self-employed individuals currently may elect to increase their self-employment income for puposes of obtaining social security coverage. Current law provides more liberal treatment for farmers as compared to other self-employed individuals. The Administration proposes to extend the favorable treatment currently accorded to farmers to other self-employed individuals. The proposal would be effective for taxable years beginning after December 31, 1999. Provide statutory hedging and other rules to ensure business property is treated as ordinary property.—Under current law, there is an issue of whether income from hedging transactions is capital or ordinary. The rules under which assets are treated as ordinary assets and under which hedging transactions are accounted for need to be modernized. In addition, the current-law rules that allow taxpayers to defer loss when a taxpayer holds a position or positions that reduce the risk of loss on certain capital assets, the socalled straddle rules, are punitive and sometimes result in a total disallowance of losses. The proposal would generally codify the hedging rules previously promulgated by the Treasury Department and make some modifications to help clarify the rules. The proposal would clarify that certain assets are ordinary assets for Federal income tax purposes and provide more equitable timing of losses under the straddle rules. The proposal generally would be effective after the date of enactment, and would give the Treasury Department 69 authority to issue regulations similar to the hedging provisions governing hedging transactions entered into prior to the effective date. Clarify rules relating to certain disclaimers.— Under current law, if a person refuses to accept (disclaims) a gift or bequest prior to accepting the transfer (or any of its benefits), the transfer to the disclaiming person generally is ignored for Federal transfer tax purposes. Current law is unclear as to whether certain transfer-type disclaimers benefit from rules applicable to other disclaimers under the estate and gift tax. Current law is also silent as to the income tax consequences of a disclaimer. The Administration proposes to extend to transfer-type disclaimers the rule permitting disclaimer of an undivided interest in property as well as the rule permitting a spouse to disclaim an interest that will pass to a trust for the spouse’s benefit. The proposal also clarifies that disclaimers are effective for income tax purposes. The proposal would apply to disclaimers made after the date of enactment. Simplify the foreign tax credit limitation for dividends from 10/50 companies.—The Taxpayer Relief Act of 1997 modified the regime applicable to indirect foreign tax credits generated by dividends from so-called 10/50 companies. Specifically, the Act retained the prior law ‘‘separate basket’’ approach with respect to pre-2003 distributions by such companies, adopted a ‘‘single basket’’ approach with respect to post-2002 distributions by such companies of their pre-2003 earnings, and adopted a ‘‘look-through’’ approach with respect to post-2002 distributions by such companies of their post-2002 earnings. The application of the three approaches results in significant additional complexity. The proposal would simplify the application of the foreign tax credit limitation significantly by applying a look-through approach immediately to dividends paid by 10/50 companies, regardless of the year in which the earnings and profits out of which the dividends are paid were accumulated (including pre-2003 years). The proposal would be effective for taxable years beginning after December 31, 1998. Provide interest treatment for certain payments from regulated investment companies to foreign persons.—Under current law, foreign investors in U.S. bond and money-market mutual funds are effectively subject to withholding tax on interest income and short term capital gains derived through such funds. Foreign investors that hold U.S. debt obligations directly generally are not subject to U.S. taxation on such interest income and gains. This proposal would eliminate the discrepancy between these two classes of foreign investors by eliminating the U.S. withholding tax on distributions from U.S. mutual funds that hold substantially all of their assets in cash or U.S. debt securities (or foreign debt securities that are not subject to withholding tax under foreign law). The proposal is designed to enhance the ability of U.S. mutual funds to attract foreign investors and to eliminate needless complica- 70 ANALYTICAL PERSPECTIVES tions now associated with the structuring of vehicles for foreign investment in U.S. debt securities. The proposal would be effective for mutual fund taxable years beginning after the date of enactment. Expand declaratory judgment remedy for noncharitable organizations seeking determinations of tax-exempt status. —Under current law, organizations seeking tax-exempt status as charities under section 501(c)(3) are allowed to seek a declaratory judgment as to their tax status if their application is denied or delayed by the IRS. A noncharity (an organization not described in section 501(c)(3)) that applies to the IRS for recognition of its tax-exempt status faces potential tax liability if its application ultimately is denied by the IRS. This creates uncertainty for the noncharity, particularly when the IRS determination is delayed for a significant period of time. To reduce this uncertainty, the declaratory judgment procedure available to charities under current-law section 7428 would be expanded, so that if the application of any organization seeking tax-exempt status under section 501(c) is pending with the IRS for more than 270 days, and the organization has exhausted all administrative remedies available within the IRS, then the organization could seek a declaratory judgment as to its tax-exempt status from the United States Tax Court. The proposal would be effective for applications for recognition of tax-exempt status filed after December 31, 1999. Simplify the active trade or business requirement for tax-free spin-offs.—In order to satisfy the active trade or business requirement for tax-free spinoffs, split-offs, and split-ups, the distributing corporation and the controlled corporation both must be engaged in the active conduct of a trade or business. If a corporation is not itself active, it may satisfy the active trade or business test indirectly, but only if substantially all of its assets consist of stock and securities of a controlled corporation that is engaged in an active trade or business. Because the substantially all standard is much higher than that required if the corporation is active itself, a taxpayer often must engage in predistribution restructurings that it otherwise would not have undertaken. There is no clear policy reason that the standards for meeting the active trade or business requirement should differ depending upon whether a corporation is considered to be active on a direct or indirect basis. Therefore, the Administration proposes to simplify the requirement by removing the substantially all test and generally allowing an affiliated group to satisfy the active trade or business requirement as long as the affiliated group, taken as a whole, is considered active. This proposal would be effective for transactions after the date of enactment. Miscellaneous Provisions Make first $2,000 of severance pay exempt from income tax.—Under current law, payments received by a terminated employee are taxable as compensation. The Administration proposes to allow an individual to exclude up to $2,000 of severance pay from income when certain conditions are met. First, the severance must result from a reduction in force by the employer. Second, the individual must not obtain a job within six months of separation with compensation at least equal to 95 percent of his or her prior compensation. Third, the total severance payments received by the employee must not exceed $75,000. The exclusion would be effective for severance pay received in taxable years beginning after December 31, 1999 and before January 1, 2003. Allow steel companies to carryback net operating losses (NOLs) up to five years.—Under current law, a net operating loss of a taxpayer generally may be carried back two years and forward 20 years. The Administration proposes to provide an immediate cash flow benefit to troubled companies in the steel industry by extending the carryback period for the NOLs of a steel company to five years. The proposal would be effective for taxable years ending after the date of enactment, regardless of when the NOL arose, and would sunset after five years. Electricity Restructuring Revise tax-exempt bond rules for electric power facilities.—As part of Federal legislation to encourage restructuring the nation’s electric power industry so that consumers benefit from competition, rules relating to the use of tax-exempt bonds to finance electric power facilities would be modified. To encourage public power systems to implement retail competition, outstanding bonds issued to finance transmission facilities would continue their tax-exempt status even if private use resulted from allowing nondiscriminatory open access to those facilities. Similarly, outstanding bonds issued to finance generation or distribution facilities would continue their tax-exempt status even if the issuer implements retail competition. To support fair competition within the restructured industry, interest on bonds to finance electric generation or transmission facilities issued after enactment of such legislation would not be exempt. Distribution facilities could continue to be financed with tax-exempt bonds. These changes would be effective upon enactment. Modify taxation of contributions to nuclear decommissioning funds.—Under current law, deductible contributions to nuclear decommissioning funds are limited to the amount included in the taxpayer’s cost of service for ratemaking purposes. For deregulated utilities, this limitation may result in the denial of any deduction for contributions to a nuclear decommissioning fund. The Administration proposes to repeal the limitation for taxable years beginning after December 31, 1999. As under current law, deductible contributions would not be permitted to exceed the amount the IRS determines to be necessary to provide for level 3. 71 FEDERAL RECEIPTS funding of an amount equal to the taxpayer’s decommissioning costs. Modify International Trade Provisions Extend and modify Puerto Rico economic-activity tax credit.—Although the Puerto Rico and possessions tax credit generally was repealed in 1996, both the income-based option and the economic-activity option under the credit remain available for existing business operations conducted in taxable years beginning before January 1, 2006, subject to base-period caps. To provide a more efficient tax incentive for the economic development of Puerto Rico and to continue the shift from an income-based credit to an economic-activity-based credit that was begun in the 1993 Act, the budget would modify the phase-out of the economicactivity-based credit for Puerto Rico (under section 30A of the Code) by (1) opening it to newly established business operations during the phase-out period, effective for taxable years beginning after December 31, 1998, and (2) extending the phase-out period through taxable years beginning before January 1, 2009. Extend the Generalized System of Preferences (GSP) and modify other trade provisions.—Under GSP, duty-free access is provided to over 4,000 items from eligible developing countries that meet certain worker rights, intellectual property protection, and other criteria. The Administration proposes to extend the program, which expires after June 30, 1999, through June 30, 2000. The Administration is proposing permanent enhanced trade benefits for subsaharan African countries undertaking strong economic reforms. The Administration also proposes to provide, through June 30, 2001, expanded trade benefits mainly on textiles and apparel to Caribbean Basin countries that meet new eligibility criteria. These benefits will help Caribbean Basin countries prepare for a future free trade agreement with the United States and respond to the effects of Hurricanes George and Mitch. The Administration also proposes to implement the OECD Shipbuilding Agreement. ELIMINATE UNWARRANTED BENEFITS AND ADOPT OTHER REVENUE MEASURES The President’s plan curtails unwarranted corporate tax subsidies, closes tax shelters and other loopholes, improves tax compliance and adopts other revenue measures. Limit Benefits of Corporate Tax Shelter Transactions The Administration is concerned about the proliferation of corporate tax shelters and their effect upon both the corporate tax base and the integrity of the tax system as a whole. The primary goals of corporate tax shelters are to manufacture tax benefits that can be used to offset unrelated income of the taxpayer or to create tax-favored or tax-exempt economic income. Corporate tax shelters may take several forms but often share certain common characteristics. Corporate tax shelter schemes are often marketed by their designers or promoters to multiple corporate taxpayers. The transactions typically involve arrangements among corporate taxpayers and persons not subject to U.S. tax. Shelters are also often associated with high transactions costs, contingent or refundable fees, unwind clauses, financial accounting treatment that is significantly more favorable than the corresponding tax treatment, and property or transactions unrelated to the corporate participant’s core business. The Administration proposes several general remedies to curb the growth of corporate tax shelters. In addition, the Administration proposes to modify the treatment of certain specific transactions that provide sheltering potential. No inference is intended as to the treatment of any of these trnsactions under current law. Levy tariff on certain textiles and apparel products produced in the Commonwealth of the Northern Mariana Islands (CNMI).—The Administration has proposed a tariff on textile and apparel products produced in the CNMI without certain percentages of workers who are U.S. citizens, nationals or permanent residents or citizens of the Pacific island nations freely associated with the U.S. Modify substantial understatement penalty for corporate tax shelters.—The current 20-percent substantial understatement penalty imposed on corporate tax shelter items can be avoided if the corporate taxpayer had reasonable cause for the tax treatment of the item and good faith. The Administration proposes to increase the substantial understatement penalty on corporate tax shelter items to 40 percent. The penalty will be reduced to 20 percent if the corporate taxpayer discloses to the National Office of the Internal Revenue Service within 30 days of the closing of the transaction appropriate documents describing the corporate tax shelter and files a statement with, and provides adequate disclosure on, its tax return. The penalty could not be avoided by a showing of reasonable cause and good faith. The proposal is effective for transactions entered into after the date of first committee action. Expand Virgin Island tariff credits.—The Administration proposes the expansion of authorized but currently unused tariff credits for wages paid in the production of watches in the Virgin Islands to be available for the production of fine jewelry. Deny certain tax benefits in corporate tax shelters.—Under curent law, if a person acquires control of a corporation or a corporation acquires carryover basis property of a corporation not controlled by the acquiring corporation or its shareholders, and the prin- 72 cipal purpose for such acquisition is evasion or avoidance of Federal income tax by securing certain tax benefits, the Secretary may disallow such benefits to the extent necessary to eliminate such evasion or avoidance of tax. However, this current rule has been interpreted narrowly. The Administration proposes to expand the current rules to authorize the Secretary to disallow a deduction, credit, exclusion, or other allowance obtained in a corporate tax shelter. The proposal would apply to transactions entered into on or after the date of first committee action. Deny deductions for certain tax advice and impose an excise tax on certain fees received.—Buyers of corporate tax shelter advice may deduct the fees paid for such advice. The proposal would deny a deduction for fees paid or accrued in connection with the promotion of corporate tax shelters and the rendering of certain tax advice related to corporate tax shelters. The proposal would also impose a 25-percent excise tax on fees received in connection with the promotion of corporate tax shelters and the rendering of certain tax advice related to corporate tax shelters. The proposal would be effective for payments made on or after the date of first committee action. Impose excise tax on certain rescission provisions and provisions guaranteeing tax benefits.— Because taxpayers entering into corporate tax shelter transactions know that such transactions are risky, particularly because the expected tax benefits are not justified economically, purchasers of corporate tax shelters often require the seller or a counterparty to enter into a tax benefit protection arrangement. The Administration proposes to impose on the purchaser of a corporate tax shelter an excise tax of 25 percent on the maximum payment to be made under the arrangement. For this purpose, a tax benefit protection arrangement would include certain rescission clauses, guarantee of tax benefits arrangement or any other arrangement that has the same economic effect (e.g., insurance purchased with respect to the transaction). The proposal would apply to arrangements entered into on or after the date of first committee action. Preclude taxpayers from taking tax positions inconsistent with the form of their transactions.— Under current law, if a taxpayer enters into a transaction in which the economic substance and the legal form are different, the taxpayer may take the position that, notwithstanding the form of the transaction, the substance is controlling for Federal income tax purposes. Many taxpayers enter into such transactions in order to arbitrage tax and regulatory laws. Under the proposal, except to the extent the taxpayer discloses the inconsistent position on its tax return, a corporate taxpayer, but not the Internal Revenue Service, would be precluded from taking any position (on a tax return or otherwise) that the Federal income tax treatment of a transaction is different from that dictated by its form, if a tax indifferent person has a direct or indirect ANALYTICAL PERSPECTIVES interest in such transaction. No inference is intended regarding the tax treatment of transactions not covered by the proposal. The proposal would be effective for transactions entered into on or after the date of first committee action. Tax income from corporate tax shelters involving tax-indifferent parties.—The Federal income tax system has many participants who are indifferent to tax consequences (e.g., foreign persons, tax-exempt organizations, and Native American tribal organizations). Many corporate tax shelters have tax-indifferent participants who absorb taxable income generated by the shelters so that corresponding losses or deductions can be allocated to taxable participants. The proposal would provide that any income received by a tax-indifferent person with respect to a corporate tax shelter would be taxable. The proposal would be effective for transactions entered into on or after the date of first committee action. Require accrual of income on forward sale of corporate stock.—There is little substantive difference between a corporate issuer’s current sale of its stock for a deferred payment and an issuer’s forward sale of the same stock. In both cases, a portion of the deferred payment compensates the issuer for the timevalue of money during the term of the contract. Under current law, the issuer must recognize the time-value element of the deferred payment as interest if the transaction is a current sale for deferred payment but not if the transaction is a forward contract. Under the proposal, the issuer would be required to recognize the time-value element of the forward contract as well. The proposal would be effective for forward contracts entered into on or after the date of first committee action. Modify treatment of built-in losses and other attribute trafficking.—Under current law, a taxpayer that becomes subject to U.S. taxation may take the position that it determines its beginning bases in its assets under U.S. tax principles as if the taxpayer had historically been subject to U.S. tax. Other tax attributes are computed similarly. A taxpayer may thus ‘‘import’’ built-in losses or other favorable tax attributes incurred outside U.S. taxing jurisdiction (e.g., from foreign or tax-exempt parties) to offset income or gain that would otherwise be subject to U.S. tax. The proposal would prevent the importation of attributes by eliminating tax attributes (including built-in items) and marking to market bases when an entity or an asset becomes relevant for U.S. tax purposes. The proposal would be effective for transactions in which assets or entities become relevant for U.S. tax purposes on or after the date of enactment. Modify treatment of ESOP as S corporation shareholder.—Pursuant to provisions enacted in 1996 and 1997, an employee stock ownership plan (ESOP) may be a shareholder of an S corporation and the ESOP’s share of the income of the S corporation is 3. FEDERAL RECEIPTS not subject to tax until distributed to the plan beneficiaries. The Administration proposes to require an ESOP to pay tax on S corporation income (including capital gains on the sale of stock) as the income is earned and to allow the ESOP a deduction for distributions of such income to plan beneficiaries. The deduction would only apply to the extent distributions exceed all prior undistributed amounts that were previously not subject to unrelated business income tax. The proposal would be effective for taxable years beginning on or after the date of first committee action. In addition, the proposal would be effective for acquisitions of S corporation stock by an ESOP after such date and for S corporation elections made on or after such date. Prevent serial liquidation of U.S. subsidiaries of foreign corporations.—When a domestic corporation distributes a dividend to a foreign corporation, it is subject to U.S. withholding tax. In contrast, if a domestic corporation distributes earnings in a subsidiary liquidation under section 332, the foreign shareholder generally is not subject to any withholding tax. Relying on section 332, some foreign corporations establish U.S. holding companies to receive tax-free dividends from operating subsidiaries, and then liquidate the holding companies, thereby avoiding the withholding tax. Subsequently, they re-establish the holding companies to receive future dividends. The proposal would impose withholding tax on any distribution made to a foreign corporation in complete liquidation of a U.S. holding company if the holding company was in existence for less than five years. The proposal would also achieve a similar result with respect to serial terminations of U.S. branches. The proposal would be effective for liquidations and terminations occurring on or after the date of first committee action. Prevent capital gains avoidance through basis shift transactions involving foreign shareholders.—A distribution in redemption of stock generally is treated as a dividend if it does not result in a meaningful reduction in the shareholder’s proportionate interest in the distributing corporation, measured with reference to certain constructive ownership rules, including option attribution. If an amount received in redemption of stock is treated as a distribution of a dividend, the basis of the remaining stock generally is increased to reflect the basis of the redeemed stock. The basis of the remaining stock is not increased, however, to the extent that the basis of the redeemed stock was reduced or eliminated pursuant to the extraordinary dividend rules. In certain circumstances, these rules require a corporate shareholder to reduce the basis of stock with respect to which a dividend is received by the nontaxed portion of the dividend, which generally equals the amount of the dividend that is offset by the dividends received deduction. To prevent taxpayers from attempting to offset capital gains by generating artificial capital losses through basis shift transactions involving foreign shareholders, the Admin- 73 istration proposes to treat the portion of a dividend that is not subject to current U.S. tax as a nontaxed portion. Similar rules would apply in the event that the foreign shareholder is not a corporation. The proposal is effective for distributions on or after the date of first committee action. Limit inappropriate tax benefits for lessors of tax-exempt use property.—Under current law, certain property leased to governments, tax-exempt organizations, or foreign persons is considered to be ‘‘tax-exempt use property.’’ There are a number of restrictions on the ability of lessors of tax-exempt use property to claim tax benefits from transactions related to the taxexempt use property. The Administration is concerned that certain structures involving tax-exempt use property are being used to generate inappropriate tax benefits for lessors. The proposal would deny a lessor the ability to recognize a net loss from a leasing transaction involving tax-exempt use property during the lease term. A lessor would be able to carry forward a net loss from a leasing transaction and use it to offset net gains from the transaction in subsequent years. The proposal would be effective for leasing transactions entered into on or after the date of enactment. Prevent mismatching of deductions and income inclusions in transactions with related foreign persons.—Current law provides that if any debt instrument having original issue discount (OID) is held by a related foreign person, any portion of such OID shall not be allowable as a deduction to the issuer until paid. Section 267 and the regulations thereunder apply similar rules to other expenses and interest owed to related foreign persons. These general rules are modified, however, so that a deduction is allowed when the OID is includible in the income of a foreign personal holding company (FPHC), controlled foreign corporation (CFC) or passive foreign investment company (PFIC). The Treasury has learned of certain structured transactions (involving both U.S. payors and U.S.-owned foreign payors) designed to allow taxpayers inappropriately to take advantage of the current rules by accruing deductions to related FPHCs, CFCs or PFICs, without the U.S. owners of such related entities taking into account for U.S. tax purposes an amount of income appropriate to the accrual. This results in an improper mismatch of deductions and income. The proposal would provide that deductions for amounts accrued but unpaid to related foreign CFCs, PFICs or FPHCs would be allowable only to the extent the amounts accrued by the payor are, for U.S. tax purposes, reflected in the income of the direct or indirect U.S. owners of the related foreign person. The proposal would contain an exception for certain short term transactions entered into in the ordinary course of business. The Secretary would be granted regulatory authority to provide exceptions from these rules. The proposal would be effective for amounts accrued on or after the date of first committee action. 74 Restrict basis creation through section 357(c).— A transferor generally is required to recognize gain on a transfer of property in certain tax-free exchanges to the extent that the sum of the liabilities assumed, plus those to which the transferred property is subject, exceeds the basis in the property. This gain recognition to the transferor generally increases the basis of the transferred property in the hands of the transferee. If a recourse liability is secured by multiple assets, it is unclear under current law whether a transfer of one asset where the transferor remains liable is a transfer of property ‘‘subject to the liability.’’ Similar issues exist with respect to nonrecourse liabilities. Under the Administration’s proposal, the distinction between the assumption of a liability and the acquisition of an asset subject to a liability generally would be eliminated. Generally, a recourse liability would be treated as assumed to the extent that the transferee has agreed and is expected to satisfy the liability (whether or not the transferor has been relieved of the liability). A nonrecourse liability would be treated as assumed by the transferee of any asset subject to the liability, but the amount of nonrecourse liability treated as assumed would be reduced by the amount of the liability which an owner of other assets not transferred to the transferee and also subject to the liability has agreed with the transferee and is expected to satisfy, up to the fair market value of such other assets. The transferor’s recognition of gain as a result of assumption of liability would not increase the transferee’s basis in the transferred asset to an amount in excess of its fair market value. Moreover, if no person is subject to U.S. tax on gain recognized as the result of the assumption of a nonrecourse liability, then the transferee’s basis in the transferred assets would be increased only to the extent such basis would be increased if the transferee had assumed only a ratable portion of the liability, based on the relative fair market values of all assets subject to such nonrecourse liability. The Treasury Department would have the authority to prescribe regulations necessary to carry out the purposes of the proposal, and to apply the treatment set forth in this proposal where appropriate elsewhere in the Code. Modify anti-abuse rule related to assumption of liabilities.—The assumption of a liability in an otherwise tax-free transaction is treated as boot to the transferor if the principal purpose of having the transferee assume the liability was the avoidance of tax on the exchange. The current language is inadequate to address the avoidance concerns that underlie the provision. The Administration proposes to modify the antiabuse rule by deleting the limitation that it only applies to tax avoidance on the exchange itself, and changing ‘‘the principal purpose’’ standard to ‘‘a principal purpose.’’ Additional conforming changes would be made. This proposal would be effective for assumptions of liabilities on or after the date of first committee action. ANALYTICAL PERSPECTIVES Modify corporate-owned life insurance (COLI) rules.—In general, interest on policy loans or other indebtedness with respect to life insurance, endowment or annuity contracts is not deductible unless the insurance contract insures the life of a ‘‘key person’’ of a business. In addition, the interest deductions of a business generally are reduced under a proration rule if the business owns or is a direct or indirect beneficiary with respect to certain insurance contracts. The COLI proration rules generally do not apply if the contract covers an individual who is a 20-percent owner of the business or is an officer, director, or employee of such business. These exceptions under current law still permit leveraged businesses to fund significant amounts of deductible interest and other expenses with tax-exempt or tax-deferred inside buildup on contracts insuring certain classes of individuals. The Administration proposes to repeal the exception under the COLI proration rules for contracts insuring employees, officers or directors (other than 20-percent owners) of the business. The proposal also would conform the key person exception for disallowed interest deductions attributable to policy loans and other indebtedness with respect to life insurance contracts to the 20-percent owner exception in the COLI proration rules. The proposal would be effective for taxable years beginning after the date of enactment. Other Proposals Require banks to accrue interest on short-term obligations.—Under current law, a bank (regardless of its accounting method) must accrue as ordinary income interest, including original issue discount, on short-term obligations. Recent court cases have held that banks that use the cash receipts and disbursements method of accounting do not have to accrue stated interest and original issue discount on short-term loans made in the ordinary course of the bank’s business. The Administration believes it is inappropriate to treat these short-term loans differently than other short-term obligations held by the bank. The Administration’s proposal would clarify that banks must accrue interest and original issue discount on all short-term obligations, including loans made in the ordinary course of the bank’s business, regardless of the banks’ overall accounting method. The proposal would be effective for obligations acquired (including originated) on or after the date of enactment. No inference is intended regarding the current-law treatment of these transactions. Require current accrual of market discount by accrual method taxpayers.—Under current law, a taxpayer that holds a debt instrument with market discount is not required to include the discount in income as it accrues, even if the taxpayer uses an accrual method of accounting. Under the proposal, a taxpayer that uses an accrual method of accounting would be required to include market discount in income as it accrues. The proposal also would cap the amount of market discount on distressed debt instruments, be- 3. FEDERAL RECEIPTS cause a portion of such discount, if realized, may be more in the nature of capital gain than interest. The proposal would be effective for debt instruments acquired on or after the date of enactment. Limit conversion of character of income from constructive ownership transactions with respect to partnership interests.—Under current law, a taxpayer can enter into a derivatives transaction that is designed to give the taxpayer the economic equivalent of an ownership interest in a partnership but that is not itself a current ownership interest in the partnership. These so-called ‘‘constructive ownership’’ transactions purportedly allow taxpayers to defer income and to convert ordinary income and short-term capital gain into long-term capital gain. The proposal would treat long-term capital gain recognized from a constructive ownership transaction as ordinary income to the extent the long-term capital gain recognized from the transaction exceeds the long-term capital gain that could have been recognized had the taxpayer invested in the partnership interest directly. In addition, the proposal would impose an interest charge on these transactions to compensate for their inherent deferral and would allow taxpayers to elect mark-to-market treatment in lieu of applying the gain recharacterization and interest charge rule. The proposal would be effective for gains recognized on or after the date of first committee action. Modify rules for debt-financed portfolio stock.— Under current law, a corporation must reduce its dividends-received deduction with respect to dividends paid on portfolio stock to the extent the portfolio stock is debt financed. For the portfolio stock to be debt financed, the indebtedness must be ‘‘directly attributable to investment in the portfolio stock.’’ This ‘‘directly attributable’’ standard is too easily avoided. Under the proposal, the percentage of portfolio stock considered to be debt financed would be equal to the sum of (1) the percentage of stock that is directly financed, and (2) the percentage of remaining stock that is indirectly financed. The proposal would be effective for portfolio stock acquired on or after the date of enactment. Modify and clarify certain rules relating to debtfor-debt exchanges.—Under current law, an issuer can inappropriately accelerate interest deductions by refinancing a debt instrument in a debt-for-debt exchange at a time when the issuer’s cost of borrowing has declined. The proposal would spread the issuer’s net deduction for bond repurchase premium in a debtfor-debt exchange over the term of the new debt instrument using constant yield principles. In addition, the proposal would modify the measurement of the net income or deduction in debt-for-debt exchanges involving contingent payment debt instruments. Finally, the proposal would modify the measurement of taxable boot to the holder in debt-for-debt exchanges that are part of corporate reorganizations. The proposal would apply to debt-for-debt exchanges occurring on or after the date of enactment. 75 Modify and clarify the straddle rules.—A ‘‘straddle’’ is the holding of two or more offsetting positions with respect to actively-traded personal property. An exception from the definition is provided for certain offsetting positions with respect to actively-traded stock. If a taxpayer enters into a straddle, the taxpayer must defer the recognition of loss from the ‘‘loss leg’’ of the straddle until the taxpayer recognizes the offsetting gain from the ‘‘gain leg’’ of the straddle. Further, the taxpayer must capitalize the net interest and carrying charges properly attributable to the straddle. The proposal would clarify that net interest expense and carrying charges arising from structured financial products that contain a leg of a straddle must be capitalized. In addition, the proposal would repeal the current-law exception for certain straddles of actively-traded stock. The proposal would be effective for straddles entered into on or after the date of enactment. Conform control test for tax-free incorporations, distributions, and reorganizations.—For tax-free incorporations, tax-free distributions, and reorganizations, ‘‘control’’ is defined as the ownership of 80 percent of the voting stock and 80 percent of the number of shares of all other classes of stock of the corporation. This test is easily manipulated by allocating voting power among the shares of a corporation, allowing corporations to retain control of a corporation but sell a significant amount of the value of the corporation. In contrast, the necessary ‘‘ownership’’ for tax-free liquidations, qualified stock purchases, and affiliation is at least 80 percent of the total voting power of the corporation’s stock and at least 80 percent of the total value of the corporation’s stock. The Administration proposes to conform the control requirement for tax-free incorporations, distributions, and reorganizations with that used for determining affiliation. This proposal is effective for transactions on or after the date of enactment. Tax issuance of tracking stock.—‘‘Tracking stock’’ is an economic interest that is intended to relate to and track the economic performance of one or more separate assets of the issuer, and gives its holder a right to share in the earnings or value of less than all of the corporate issuer’s earnings or assets. The use of tracking stock is clearly outside the contemplation of subchapter C and other sections of the Code. As a result, a principal consequence of treating such a stock interest as stock of the issuer is the potential avoidance of these provisions. The Administration proposes to define ‘‘tracking stock’’ as stock that is linked to the performance of assets of the issuing corporation with one or more identified characteristics and provide that gain will be recognized on the issuance of tracking stock. Under this proposal, the Secretary would have authority to treat tracking stock as nonstock (e.g., debt, a notional principal contract, etc.) or as stock of another entity as appropriate to prevent avoidance. No inference is intended regarding the tax treatment of tracking 76 stock under current law. This proposal is effective for tracking stock issued on or after the date of enactment. Require consistent treatment and provide basis allocation rules for transfers of intangibles in certain nonrecognition transactions.—No gain or loss will be recognized if one or more persons transfer property to a controlled corporation (or partnership) solely in exchange for stock in the corporation (or a partnership interest). Where there is a transfer of less than ‘‘all substantial rights’’ to use property, the Internal Revenue Service’s position is that such transfer will not qualify as a tax-free exchange. However, the Claims Court rejected the Service’s position in E.I. Du Pont de Nemours and Co. v. U.S., holding that any transfer of something of value could be a ‘‘transfer’’ of ‘‘property.’’ The inconsistency between the positions has resulted in whipsaw of the government. The Administration proposes to provide that the transfer of an interest in intangible property constituting less than all of the substantial rights of the transferor in the property is a transfer of property entitled to tax-free treatment, and the transferor must allocate the basis of the intangible between the retained rights and the transferred rights based upon respective fair market values. Consistent reporting by the transferor and the transferee would be required. This proposal is effective for transfers on or after the date of enactment. Modify tax treatment of downstream mergers.— If a target corporation owns stock in an acquiring corporation and wants to combine with the acquiring corporation in a downstream transaction, the target corporation transfers its assets to the acquiring corporation, and the shareholders of the target corporation receive stock of the acquiring corporation in exchange for their target corporation stock. Downstream transactions have been held to qualify as tax-free reorganizations. In substance, however, this transaction is a distribution by the target corporation of its acquiring corporation stock to its shareholders, which otherwise would result in gain recognized by the target corporation. Under the proposal, where a target corporation holds less than 80 percent of the stock of an acquiring corporation, and the target corporation combines with the acquiring corporation in a reorganization in which the acquiring corporation is the survivor, the target corporation must recognize gain, but not loss, as if it distributed the acquiring corporation stock that it held immediately prior to the reorganization. Nonrecognition treatment would continue to apply to other assets transferred by the target corporation and to the target corporation shareholders. The proposal would apply to similar transactions: for example, where stock of the target corporation is acquired by the acquiring corporation in a transaction qualifying as a reorganization, and the target corporation is liquidated pursuant to a plan of liquidation adopted not more than two years after the acquisition date. This proposal applies to transactions that occur on or after the date of enactment. ANALYTICAL PERSPECTIVES Provide mandatory basis adjustments with respect to partnership distributions.—The basis of partnership property is not adjusted upon a distribution of property to a partner unless a special election is in effect. If such an election is in effect, a partnership must increase the basis of partnership property in certain circumstances and decrease its basis in partnership property in other situations. The electivity of these adjustments provides substantial opportunities for taxpayer abuse. Accordingly, the Administration proposes that basis adjustments in connection with partnership distributions be made mandatory. In addition, unlike current law, the basis adjustment would be measured by reference to the difference between the basis of the distributed property and the amount by which the distributee partner’s proportionate share of the adjusted basis of partnership property is reduced by the distribution. This proposal would apply to partnership distributions made on or after the date of enactment. Modify rules for allocation of basis adjustments for partnership distributions.—Under current law, a partner’s basis in distributed property is allocated first to unrealized receivables and inventory items in an amount equal to the adjusted basis of each such property to the partnership, with any remaining basis being allocated among the other distributed property. This basis allocation scheme is intended to prevent partners from shifting basis from capital assets to ordinary income assets. While generally accomplishing this goal, the allocation scheme still allows for a shifting of basis from non-depreciable assets to depreciable assets. The proposal would modify the rule for basis allocations in the event of a liquidation of a partner’s interest to include three asset classes: (1) inventory, unrealized receivables and other inventory assets, (2) depreciable assets, and (3) non-depreciable assets. Basis would be allocated in the first two categories up to the partnership’s basis in such assets. Residual basis would be allocated to the third category of assets. The partnership’s inside asset basis adjustments made in connection with partnership distributions would be determined in the same manner. Basis adjustments relating to transfers of partnership interests would not be affected by this proposal. This proposal would apply to partnership distributions made on or after the date of enactment. Modify rules for partial liquidations of a partnership.—A partner recognizes gain or loss upon a distribution from a partnership in certain limited circumstances. The basis of property distributed to a partner other than in liquidation of the partner’s interest generally is its adjusted basis to the partnership, while the basis of property distributed to a partner in liquidation of the partner’s interest is equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction. These rules provide for an inappropriate deferral of gain with respect to certain partnership distributions and also allow for a misallocation of basis in many 3. FEDERAL RECEIPTS instances. The Administration proposes to treat a partial liquidation of a partner’s interest in a partnership as a complete liquidation of that portion of the partner’s interest. A partial liquidation would be a reduction in a partner’s percentage share of capital, and the percentage that is reduced would be treated as a separate interest that was completely liquidated in the distribution. This proposal would apply to partnership distributions made on or after the date of enactment. Repeal rules relating to distributions treated as sales or exchanges with respect to unrealized receivables and inventory items.—Under current law, to the extent that a partner receives (1) unrealized receivables or substantially appreciated inventory in exchange for all or part of its interest in other partnership property, or (2) partnership property other than unrealized receivables or substantially appreciated inventory in exchange for all or part of its interest in partnership property that is unrealized receivables or substantially appreciated inventory, such transactions are, under regulations, treated as a sale or exchange of such property between the distributee and the partnership. This rule, which often has been criticized as being overly complex, was designed to prevent taxpayers from converting ordinary income to capital gains through partnership distributions where the distributee partner essentially transferred his share of ordinary income assets to the partnership in exchange for capital gain assets or vice versa. The proposals discussed above would prevent positive basis adjustments from being made to ordinary income assets, which would greatly reduce the ability to carry out such abuses. Accordingly, the Administration proposes that this rule be repealed. This proposal would apply to partnership distributions made on or after the date of enactment. Require basis adjustments when a partnership distributes certain stock to a corporate partner.— The basis of property distributed to a partner in liquidation of the partner’s interest is equal to the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction. Generally, no gain or loss is recognized on the receipt by a corporation of property distributed in complete liquidation of an 80-percent-owned subsidiary corporation. The basis of property received by the distributee in such a corporate liquidation is the same as it was in the hands of the transferor. These corporate liquidation rules provide taxpayers with the ability to negate the effect of downward basis adjustments by having a partnership contribute property to a corporation prior to a liquidating distribution to a corporate partner. The proposal would require that if stock of a corporation is distributed to a corporate partner that, as a result of the distribution and related transactions, owns 80 percent or more of the stock of such corporation, then the distributed corporation must reduce the basis of its assets by an amount equal to the amount by which the stock basis is reduced as a result of the distribution. The basis must be reduced 77 using the same methodology as is used in the partnership liquidation rules, determined as if the corporation’s assets were being distributed. This proposal would apply to partnership distributions made on or after the date of enactment. Deny change in method treatment to tax-free formations.—Generally, a taxpayer that desires to change its method of accounting must obtain the consent of the Commissioner. In addition, in a transaction to which section 381 applies, a corporation acquiring assets generally is required to use the method of accounting used for those assets by the distributor or transferor corporation. Under current law, section 381 does not apply to tax-free contributions to a corporation or to a partnership. Consequently, taxpayers who transfer assets to a subsidiary or a partnership in a transaction to which section 351 or section 721 applies may avail themselves of a new method of accounting without obtaining the consent of the Commissioner. The Administration proposes to expand the transactions to which the carryover of method of accounting rules in section 381 and the regulations thereunder apply to include tax-free contributions to corporations or partnerships effective for transfers on or after the date of enactment. Repeal installment method for accrual basis taxpayers.—Generally, an accrual method requires a taxpayer to recognize income when all events have occurred that fix the right to its receipt and its amount can be determined with reasonable accuracy. The installment method of accounting provides an exception to these general recognition principles by allowing a taxpayer to defer recognition of income from the disposition of certain property until payment is received. To the extent that an installment obligation is pledged as security for any indebtedness, the net proceeds of the secured indebtedness are treated as a payment on such obligation, thereby triggering the recognition of income. The installment method is inconsistent with an accrual method of accounting and effectively allows an accrual method taxpayer to recognize income from certain property using the cash receipts and disbursements method. Consequently, the method fails to reflect the economic results of a taxpayer’s business during the taxable year. In addition, the pledging rules, which are designed to require the recognition of income when the taxpayer receives cash related to an installment obligation, are inadequate. The Administration proposes to repeal the installment method of accounting for accrual method taxpayers and to eliminate the inadequacies in the pledging rules for installment sales entered into on or after the date of enactment. Deny deduction for punitive damages.—The current deductibility of most punitive damage payments undermines the role of such damages in discouraging and penalizing certain undesirable actions or activities. The Administration proposes to disallow any deduction for punitive damages paid or incurred by the taxpayer, whether upon a judgment or in settlement of a claim. 78 Where the liability for punitive damages is covered by insurance, such damages paid or incurred by the insurer would be included in the gross income of the insured person. The insurer would be required to report such payments to the insured person and to the Internal Revenue Service. The proposal would apply to damages paid or incurred on or after the date of enactment. Apply uniform capitalization rules to tollers.— The uniform capitalization rules require the capitalization of the direct costs, and an allocable portion of the indirect costs, of real or tangible personal property produced by a taxpayer or of real or personal property that is acquired by a taxpayer for resale. Costs attributable to producing or acquiring property generally must be capitalized by charging such costs to basis or, in the case of property which is inventory in the hands of the taxpayer, by including such costs in inventory. In general, a toller charges a fee (known as a toll) to perform certain manufacturing or processing operations on property which is provided by its customers. Since the toller does not take title to the property, it contends that it does not produce property or acquire property for resale. As a result, a toller does not capitalize certain direct and indirect costs attributable to its tolling activities. The Administration believes that the disparate treatment between tollers and manufacturers based on ownership of the raw materials leads to inequitable results. Thus, the uniform capitalization rules would be modified to require tollers to capitalize both their direct costs, and a portion of their indirect costs, allocable to property tolled. An exception would be provided for small businesses. The proposal would be effective for taxable years beginning on or after the date of enactment. Provide consistent amortization periods for intangibles.—Under current law, start-up and organizational expenditures are amortized at the election of the taxpayer over a period of not less than 5 years. Current law requires certain acquired intangible assets (goodwill, trademarks, franchises, patents, etc.) to be amortized over 15 years. The Administration believes that, to encourage the formation of new businesses, a fixed amount of start-up and organizational expenditures should be currently deductible. Thus, the proposal would allow a taxpayer to elect to deduct up to $5,000 each of start-up or organizational expenditures. However, for each taxpayer, the $5,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of start-up or organizational expenditures exceeds $50,000. Start-up and organizational expenditures not currently deductible would be amortized over a 15-year period consistent with the amortization period for acquired intangible assets. The proposal generally would be effective for start-up and organizational expenditures incurred in taxable years beginning on or after the date of enactment. Clarify recovery period of utility grading costs. —A taxpayer is allowed as a depreciation deduction ANALYTICAL PERSPECTIVES a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property that is used in a trade or business or held for the production of income. For most tangible property placed in service after 1986, the amount of the depreciation deduction is determined under the modified accelerated cost recovery system (MACRS) using a statutorily prescribed depreciation method, recovery period, and placed in service convention. The recovery period may be determined by reference to the statutory recovery period or to the list of class lives provided by the Treasury Department. Electric and gas utility clearing and grading costs incurred to extend distribution lines and pipelines have not been assigned a class life. By default, such assets have a seven-year recovery period under MACRS. The Administration believes that the recovery period used for electric and gas utility clearing and grading costs does not reflect the economic useful life of such costs. For example, the electric utility transmission and distribution lines and the gas utility trunk pipelines benefitted by the clearing and grading costs have MACRS recovery periods of 20 years and 15 years, respectively. The proposal would assign depreciable electric and gas utility clearing and grading costs incurred to locate transmission and distribution lines and pipelines to the class life assigned to the benefitted assets, giving these costs a recovery period of 20 years and 15 years, respectively. The proposal would be effective for electric and gas utility clearing and grading costs incurred on or after the date of enactment. Require recapture of policyholder surplus accounts.—Between 1959 and 1984, stock life insurance companies deferred tax on a portion of their profits. These untaxed profits were added to a policyholders surplus account (PSA). In 1984, Congress precluded life insurance companies from continuing to defer tax on future profits through PSAs. However, companies were permitted to continue to defer tax on their existing PSAs, and to pay tax on the previously untaxed profits in the PSAs only in certain circumstances. There is no remaining justification for allowing these companies to continue to defer tax on profits they earned between 1959 and 1984. Most pre-1984 policies have terminated, because pre-1984 policyholders have surrendered their pre-1984 contracts for cash, ceased paying premiums on those contracts, or died. The Administration proposes that companies generally would be required to include in their gross income over ten years their PSA balances as of the beginning of the first taxable year starting on or after the date of enactment. Modify rules for capitalizing policy acquisition costs of life insurance companies.—Under current law, insurance companies capitalize varying percentages of their net premiums for certain types of insurance contracts, and generally amortize these amounts over 10 years (five years for small companies). These capitalized amounts are intended to serve as proxies for each company’s actual commissions and other policy acquisition expenses. However, data reported by insur- 3. FEDERAL RECEIPTS ance companies to State insurance regulators each year indicates that the insurance industry is capitalizing less than half of its policy acquisition costs, which results in a mismatch of income and deductions. The Administration proposes that insurance companies be required to capitalize modified percentages of their net premiums for certain lines of business. The percentages would be modified once in the first taxable year beginning after the date of enactment, and a second time in the sixth taxable year beginning after the date of enactment. The final modified percentages would more accurately reflect the ratio of actual policy acquisition expenses to net premiums and the typical useful lives of the contracts. To ensure that companies are not required to capitalize more under this proxy approach than they would capitalize under normal tax accounting rules, companies that have low policy acquisition costs generally would be permitted to capitalize their actual policy acquisition costs. Subject investment income of trade associations to tax.—Trade associations described in section 501(c)(6) generally are exempt from Federal income tax, but are subject to tax on their unrelated business income. Under the proposal, trade associations that have net investment income in excess of $10,000 for any taxable year would be subject to the unrelated business income tax on their excess net investment income. As under current-law section 512(a)(3), investment income would not be subject to tax under the proposal to the extent that it is set aside for a charitable purpose specified in section 170(c)(4). In addition, any gain from the sale of property used directly in the performance of the trade association’s exempt function would not be subject to tax under the proposal to the extent that the sale proceeds are used to purchase replacement exempt-function property. The proposal would be effective for taxable years beginning on or after the date of enactment. Restore phaseout of unified credit for large estates.—Prior to the Taxpayer Relief Act of 1997, the benefit of both the estate tax graduated rate brackets below fifty-five percent and the unified credit were phased out by imposing a five-percent surtax on estates with a value above $10 million. When the Taxpayer Relief Act of 1997 increased the unified credit amount, the phase out of the unified credit was inadvertently omitted. The Administration proposes to restore the surtax in order to phase out the benefits of the unified credit as well as the graduated estate tax brackets. The proposal would be effective for decedents dying after the date of enactment. Require consistent valuation for estate and income tax purposes.—The basis of property acquired from a decedent generally is its fair market value on the date of death. Property included in the gross estate of a decedent is valued also at its fair market value on the date of death. Recipients of lifetime gifts generally take a carryover basis in the property received. 79 The Administration proposes to impose a duty of consistency on heirs receiving property from a decedent, requiring such heirs to use the value as reported on the estate tax return as the basis for the property for income tax purposes. Estates would be required to notify heirs (and the IRS) of such values. In addition, donors making lifetime gifts would be required to notify the recipients of such gifts (and the IRS) of the donor’s basis in the property at the time of the gift, as well as any gift tax paid with respect to the gift. This proposal would be effective for gifts made after, and decedents dying after, the date of enactment. Require basis allocation for part sale/part gift transactions.—In a part gift, part sale transaction, the donee/purchaser takes a basis equal to the greater of the amount paid by the donee or the donor’s adjusted basis at the time of the transfer. The donor/seller uses adjusted cost basis in computing the gain or loss on the sale portion of the transaction. The Administration proposes to rationalize basis allocation in a part gift, part sale transaction by requiring the basis of the property to be allocated ratably between the gift portion and the sale portion based on the fair market value of the property on the date of transfer and the consideration paid. This proposal would be effective for transactions entered into on or after the date of enactment. Conform treatment of surviving spouses in community property States.—If joint property is owned by spouses in a non-community property state, a surviving spouse receives a stepped-up basis only in the half of the property owned by the deceased spouse. In contrast, when a spouse dies owning community property, the surviving spouse is entitled to a stepped-up basis not only in the half of the property owned by the deceased spouse, but also in the half of the property already owned by the surviving spouse prior to the decedent’s death. The Administration proposes to eliminate the stepped-up basis in the part of the community property owned by the surviving spouse prior to the deceased spouse’s death. The half of the community property owned by the deceased spouse would continue to be entitled to a stepped-up basis upon death. This treatment will be consistent with the treatment of joint property owned by spouses in a non-community property State. This proposal would be effective for decedents dying after the date of enactment. Expand section 864(c)(4)(B) to interest and dividend equivalents.—Under U.S. domestic law, a foreign person is subject to taxation in the United States on a net income basis with respect to income that is effectively connected with a U.S. trade or business (ECI). The test for determining whether income is effectively connected to a U.S. trade or business differs depending on whether the income at issue is U.S. source or foreign source. Only enumerated types of foreign source income—rents, royalties, dividends, interest, gains from the sale of inventory property, and insurance income—constitute ECI, and only in certain cir- 80 cumstances. The proposal would expand the categories of foreign-source income that could constitute ECI to include interest equivalents (including letter of credit fees) and dividend equivalents in order to eliminate arbitrary distinctions between economically equivalent transactions. Recapture overall foreign losses when CFC stock is disposed.—Under the interest allocation rules of section 864(e), the value of stock in a controlled foreign corporation (CFC) is added to the value of directlyowned foreign assets, and then compared to the value of domestic assets of a corporation (or a group of affiliated U.S. corporations) for purposes of determining how much of the corporation’s interest deductions should be allocated against foreign income and how much against domestic income. If these deductions against foreign income result in (or increase) an overall foreign loss which is then set against U.S. income, section 904(f) has recapture rules that require subsequent foreign income or gain to be recharacterized as domestic. Recapture can take place when directly-owned foreign assets, for example, are disposed of. However, there may be no recapture when stock in a CFC is disposed of. The proposal would correct that asymmetry by providing that property subject to the recapture rules upon disposition under section 904(f)(3) would include stock in a CFC. Increase elective withholding rate for nonperiodic distributions from deferred compensation plans.—The Administration proposes to increase the current 10-percent elective withholding rate for nonperiodic distributions (such as certain lump sums) from pensions, IRAs and annuities to 15 percent, which more closely approximates the taxpayer’s income tax liability for the distribution effective for distributions after 1999. The withholding would not apply to eligible rollover distributions. Increase section 4973 excise tax for excess IRA contributons.—Excess IRA contributions are currently subject to an annual six-percent excise tax. With high investment returns, this annual six-percent rate may be insufficient to discourage contributions in excess of the current limits for IRAs. The Administration proposes to increase from six percent to 10 percent the excise tax on excess contributions to traditional and Roth IRAs for taxable years after the year the excess contribution is made. Thus, the six-percent rate would continue to apply for the year of the excess contribution and a higher annual rate would apply if excess amounts remain in the IRA. This increase would be effective for taxable years beginning after 1999. Limit pre-funding of welfare benefits for 10 or more employer plans.—Current law generally limits the ability of employers to claim a deduction for amounts used to prefund welfare benefits. An exception is provided for certain arrangements where 10 or more employers participate because it is believed that such ANALYTICAL PERSPECTIVES relationships involve risk-sharing similar to insurance which will effectively eliminate any incentive for participating employers to prefund benefits. However, as a practical matter, it has proven difficult to enforce the risk-sharing requirements in the context of certain arrangements. The Administration proposes to limit the 10 or more employer plan funding exception to medical, disability, and group-term life insurance benefits because these benefits do not present the same risk of prefunding abuse. Thus, effective for contributions paid on or after the date of enactment, the existing deduction rules would apply to prevent an employer who contributes to a 10 or more employer plan from claiming a current deduction for supplemental unemployment benefits, severance pay or life insurance (other than group-term life insurance) benefits to be paid in future years. Subject signing bonuses to employment taxes.— Bonuses paid to individuals for signing a first contract of employment are ordinary income in the year received. The Administration proposes to clarify that these amounts are treated as wages for purposes of income tax withholding and FICA taxes effective after the date of enactment. No inference is intended with respect to the application of prior law withholding rules to signing bonuses. Expand reporting of cancellation of indebtedness income.—Under current law, gross income generally includes income from the discharge of indebtedness. If a bank, thrift institution, or credit union discharges $600 or more of any indebtedness of a debtor, the institution must report such discharge to the debtor and the IRS. The proposal would extend these reporting requirements to additional entities involved in the trade or business of lending for discharges of indebtedness occurring on or after the date of enactment. Require taxpayers to include rental income of residence in income without regard to the period of rental.—Under current law, rental income is generally includable in income and the deductibility of expenses attributable to the rental property is subject to certain limitations. An exception to this general treatment applies if a dwelling is used by the taxpayer as a residence and is rented for less than 15 days during the taxable year. The income from such a rental is not included in gross income and no expenses arising from the rental are deductible. The Administration proposes to repeal this 15-day exception. The proposal would apply to taxable years beginning after December 31, 1999. Repeal lower-of-cost-or-market inventory accounting method.—Taxpayers required to maintain inventories are permitted to use a variety of methods to determine the cost of their ending inventories, including the last-in, first-out (LIFO) method, the firstin, first-out (FIFO) method, and the retail method. Taxpayers not using a LIFO method may determine the 3. FEDERAL RECEIPTS carrying values of their inventories by applying the lower-of-cost-or-market (LCM) method or by writing down the cost of goods that are unsalable at normal prices or unusable in the normal way because of damage, imperfection or other similar causes (subnormal goods method). The allowance of write-downs under the LCM and subnormal goods methods is essentially a one-way mark-to-market method that understates taxable income. The Administration proposes to repeal the LCM and subnormal goods methods effective for taxable years beginning after the date of enactment. Defer interest deduction and original issue discount (OID) on certain convertible debt.—The accrued but unpaid interest and OID on a convertible debt instrument generally is deductible, even if the instrument is converted into the stock of the issuer or a related party before the issuer pays any interest or OID. The Administration proposes to defer the deduction for all interest, including OID, on convertible debt until payment. The proposal would be effective for convertible debt issued on or after the date of first committee action. Modify deposit requirement for Federal Unemployment Act (FUTA).—Beginning in 2005, the Administration proposes to require an employer to pay Federal and State unemployment taxes monthly (instead of quarterly) in a given year, if the employer’s FUTA tax liability in the immediately preceding year was $1,100 or more. Reinstate Oil Spill Liability Trust Fund tax.— Before January 1, 1995, a five-cents-per-barrel excise tax was imposed on domestic crude oil and imported oil and petroleum products. The tax was dedicated to the Oil Spill Liability Trust Fund to finance the cleanup of oil spills and was not imposed for a calendar quarter if the unobligated balance in the Trust Fund exceeded $1 billion at the close of the preceding quarter. The Administration proposes to reinstate this tax for the period after the date of enactment and before October 1, 2009. The tax would be suspended for a given calendar quarter if the unobligated Trust Fund balance at the end of the preceding quarter exceeded $5 billion. Deny dividends-received deduction for certain preferred stock.—A corporate holder of stock generally is entitled to a deduction for dividends received on stock in the following amounts: 70 percent if the recipient owns less than 20 percent of the stock of the payor, 80 percent if the recipient owns 20 percent or more of the stock, and 100 percent of ‘‘qualifying dividends’’ received from members of the same affiliated group. The Administration proposes to eliminate the dividends-received deduction for dividends on nonqualified preferred stock (as defined in section 351(g)), except in the case of ‘‘qualifying dividends.’’ This proposal is effective for nonqualified preferred stock issued after the date of first committee action. 81 Disallow interest on debt allocable to tax-exempt obligations.—No income tax deduction is allowed for interest on debt used directly or indirectly to acquire or hold investments that produce tax-exempt income. The determination of whether debt is used to acquire or hold tax-exempt investments differs depending on the holder of the instrument. For banks and a limited class of other financial institutions, debt generally is treated as financing all of the taxpayer’s assets proportionately. Securities dealers are not included in the definition of ‘‘financial institution,’’ and under a special rule are subject to a disallowance of a much smaller portion of their interest deduction. For other financial intermediaries, such as finance companies, that are also not included in the narrow definition of ‘‘financial institutions,’’ deductions are disallowed only when indebtedness is incurred or continued for the purpose of purchasing or carrying tax-exempt investments. These taxpayers are therefore able to reduce their tax liabilities inappropriately through the double Federal tax benefits of interest expense deductions and tax-exempt interest income, notwithstanding that they operate similarly to banks. Effective for taxable years beginning after the date of enactment, with respect to obligations acquired on or after the date of first committee action, the Administration proposes that all financial intermediaries, other than insurance companies (which are subject to a separate regime), be treated the same as banks are treated under current law with regard to deductions for interest on debt used directly or indirectly to acquire or hold tax-exempt obligations. Repeal percentage depletion for non-fuel minerals mined on Federal and formerly Federal lands.—Taxpayers are allowed to deduct a reasonable allowance for depletion relating to certain mineral deposits. The depletion deduction for any taxable year is calculated under either the cost depletion method or the percentage depletion method, whichever results in the greater allowance for depletion for the year. The percentage depletion method is viewed as an incentive for mineral production rather than as a normative rule for recovering the taxpayer’s investment in the property. This incentive is excessive with respect to minerals mined on Federal and formerly Federal lands under the 1872 mining act, in light of the minimal costs of acquiring the mining rights ($5.00 or less per acre). The Administration proposes to repeal percentage depletion for non-fuel minerals mined on Federal lands where the mining rights were originally acquired under the 1872 law, and on private lands acquired under the 1872 law. The proposal would be effective for taxable years beginning after the date of enactment. Modify rules relating to foreign oil and gas extraction income.—To be eligible for the U.S. foreign tax credit, a foreign levy must be the substantial equivalent of an income tax in the U.S. sense, regardless of the label the foreign government attaches to it. Under regulations, a foreign levy is a tax if it is a compulsory payment under the authority of a foreign 82 government to levy taxes and is not compensation for a specific economic benefit provided by the foreign country. Taxpayers that are subject to a foreign levy and that also receive (directly or indirectly) a specific economic benefit from the levying country are referred to as ‘‘dual capacity’’ taxpayers and may not claim a credit for that portion of the foreign levy paid as compensation for the specific economic benefit received. The Administration proposes to treat as taxes payments by a dualcapacity taxpayer to a foreign country that would otherwise qualify as income taxes or ‘‘in lieu of’’ taxes, only if there is a ‘‘generally applicable income tax’’ in that country. For this purpose, a generally applicable income tax is an income tax (or a series of income taxes) that applies to trade or business income from sources in that country, so long as the levy has substantial application both to non-dual-capacity taxpayers and to persons who are citizens or residents of that country. Where the foreign country does generally impose an income tax, as under present law, credits would be allowed up to the level of taxation that would be imposed under that general tax, so long as the tax satisfies the new statutory definition of a ‘‘generally applicable income tax.’’ The proposal also would create a new foreign tax credit basket within section 904 for foreign oil and gas income. The proposal would be effective for taxable years beginning after the date of enactment. The proposal would yield to U.S. treaty obligations that allow a credit for taxes paid or accrued on certain oil or gas income. Increase penalties for failure to file correct information returns.—Any person who fails to file required information returns in a timely manner or incorrectly reports such information is subject to penalties. For taxpayers filing large volumes of information returns or reporting significant payments, existing penalties ($15 per return, not to exceed $75,000 if corrected within 30 days; $30 per return, not to exceed $150,000 if corrected by August 1; and $50 per return, not to exceed $250,000 if not corrected at all) may not be sufficient to encourage timely and accurate reporting. The Administration proposes to increase the general penalty amount, subject to the overall dollar limitations, to the greater of $50 per return or 5 percent of the total amount required to be reported. The increased penalty would not apply if the aggregate amount actually reported by the taxpayer on all returns filed for that calendar year was at least 97 percent of the amount required to be reported. The increased penalty would be effective for returns the due date for which is more than 90 days after the date of enactment. Tighten the substantial understatement penalty for large corporations.—Currently taxpayers may be penalized for erroneous, but non-negligent, return positions if the amount of the understatement is ‘‘substantial’’ and the taxpayer did not disclose the position in a statement with the return. ‘‘Substantial’’ is defined as 10 percent of the taxpayer’s total current tax liability, but this can be a very large amount. This has ANALYTICAL PERSPECTIVES led some large corporations to take aggressive reporting positions where huge amounts of potential tax liability are at stake—in effect playing the audit lottery—without any downside risk of penalties if they are caught, because the potential tax still would not exceed 10 percent of the company’s total tax liability. To discourage such aggressive tax planning, the Administration proposes that any deficiency greater than $10 million be considered ‘‘substantial’’ for purposes of the substantial understatement penalty, whether or not it exceeds 10 percent of the taxpayer’s liability. The proposal, which would be effective for taxable years beginning after the date of enactment, would affect only taxpayers that have tax liabilities greater than or equal to $100 million. Require withholding on certain gambling winnings —Proceeds of most wagers with odds of less than 300 to 1 are exempt from withholding, as are all bingo and keno winnings. The Administration proposes to impose withholding on proceeds of bingo or keno in excess of $5,000 at a rate of 28 percent, regardless of the odds of the wager, effective for payments made after the start of the first calendar quarter that is at least 30 days after the date of enactment. Simplify foster child definition under EITC.—In order to simplify the EITC rules, the Administration proposes to clarify the definition of foster child for purposes of claiming the EITC. Under the proposal, the foster child must be the taxpayer’s sibling (or a descendant of the taxpayer’s sibling), or be placed in the taxpayer’s home by an agency of a State or one of its political subdivisions or a tax-exempt child placement agency licensed by a State. The proposal would be effective for taxable years beginning after December 31, 1999. Replace sales-source rules with activity-based rules.—If inventory is manufactured in the United States and sold abroad, Treasury regulations provide that 50 percent of the income from such sales is treated as earned by production activities and 50 percent by sales activities. The income from the production activities is sourced on the basis of the location of assets held or used to produce the income. The income from the sales activity (the remaining 50 percent) is sourced based on where title to the inventory transfers. If inventory is purchased in the United States and sold abroad, 100 percent of the sales income generally is deemed to be foreign source. These rules generally produce more foreign source income for United States tax purposes than is subject to foreign tax. Thus, the rules generally increase the U.S exporters’ foreign tax credit limitation and thereby allow U.S. exporters that operate in high-tax foreign countries to credit tax in excess of the U.S. rate against their U.S. tax liability. The proposal would require that the allocation between production activities and sales activities be based on actual economic activity. The proposal would be effec- 3. FEDERAL RECEIPTS tive for taxable years beginning after the date of enactment. Repeal tax-free conversions of large C corporations to S corporations.—A corporation can avoid the existing two-tier tax by electing to be treated as an S corporation or by converting to a partnership. Converting to a partnership is a taxable event that generally requires the corporation to recognize any builtin gain on its assets and requires the shareholders to recognize any built-in gain on their stock. By contrast, the conversion to an S corporation is generally taxfree, except that the S corporation generally must recognize the built-in gain on assets held at the time of conversion if the assets are sold within ten years. The Administration proposes that the conversion of a C corporation with a value of more than $5 million into an S corporation would be treated as a liquidation of the C corporation, followed by a contribution of the assets to an S corporation by the recipient shareholders. Thus, the proposal would require immediate gain recognition by both the corporation (with respect to its appreciated assets) and its shareholders (with respect to their stock). This proposal would make the tax treatment of conversions to an S corporation generally consistent with conversions to a partnership. The proposal would apply to elections that are first effective for a taxable year beginning after January 1, 2000 and to acquisitions of a C corporation by an S corporation made after December 31, 1999. Eliminate the income recognition exception for accrual method service providers.—An accrual method taxpayer generally must recognize income when all events have occurred that fix the right to its receipt and its amount can be determined with reasonable accuracy. In the event that a receivable arising in the ordinary course of the taxpayer’s trade or business becomes uncollectible, the accrual method taxpayer may deduct the account receivable as a business bad debt in the year in which it becomes wholly or partially worthless. Accrual method service providers, however, are provided a special exception to these general rules. Under the exception, a taxpayer using an accrual method with respect to amounts to be received for the performance of services is not required to accrue any portion of such amounts that (on the basis of experience) will not be collected. This special exception permits an accrual method service provider to reduce current taxable income by an estimate of its future bad debt losses. This method of estimation results in a mismeasurement of a taxpayer’s economic income and, because this tax benefit only applies to amounts to be received for the performance of services, promotes controversy over whether a taxpayer’s receivables represent amounts to be received for the performance of services or for the provision of goods. The Administration proposes to repeal the special exception for accrual method service providers effective for taxable years beginning after the date of enactment. 83 Modify structure of businesses indirectly conducted by REITs.—REITs generally are restricted to owning passive investments in real estate and certain securities. No single corporation can account for more than five percent of the total value of a REIT’s assets, and a REIT cannot own more than 10 percent of the outstanding voting securities of any issuer. Through the use of non-voting preferred stock and multiple subsidiaries, up to 25 percent of the value of a REIT’s assets can consist of subsidiaries that conduct otherwise impermissible activities. Under the proposal, the 10percent vote test would be changed to a ‘‘vote or value’’ test. This would prevent REITs from undertaking impermissible activities through preferred stock subsidiaries. However, the proposal also would provide an exception to the five- and 10-percent asset tests so that REITs could have ‘‘taxable REIT subsidiaries’’ that would be allowed to perform non-customary and other currently prohibited services with respect to REIT tenants and other customers. Under the proposal, there would be two types of taxable REIT subsidiaries, a ‘‘qualified independent contractor subsidiary’’ and a ‘‘qualified business subsidiary.’’ A qualified business subsidiary would be allowed to undertake non-tenant related activities that currently generate bad income for a REIT. A qualified independent contractor subsidiary would be allowed to perform non-customary and other currently prohibited services with respect to REIT tenants as well as activities that could be performed by a qualified business subsidiary. All taxable REIT subsidiaries owned by a REIT could not represent more than 15 percent of the value of the REIT’s total assets, and within that 15-percent limitation, no more than five percent of the total value of a REIT’s assets could consist of qualified independent contractor subsidiaries. A number of additional constraints would be imposed on a taxable REIT subsidiary to ensure that the taxable REIT subsidiary pays a corporate level tax on its earnings. This proposal would be effective after the date of enactment. REITs would be allowed to combine and convert preferred stock subsidiaries into taxable REIT subsidiaries tax-free prior to a certain date. Modify treatment of closely held REITs.—When originally enacted, the REIT legislation was intended to provide a tax-favored vehicle through which small investors could invest in a professionally managed real estate portfolio. REITs are intended to be widely held entities, and certain requirements of the REIT rules are designed to ensure this result. Among other requirements, in order for an entity to qualify for REIT status, the beneficial ownership of the entity must be held by 100 or more persons. In addition, a REIT cannot be closely held, which generally means that no more than 50 percent of the value of the REIT’s stock can be owned by five or fewer individuals during the last half of the taxable year. Certain attribution rules apply in making this determination. The Administration has become aware of a number of tax avoidance transactions involving the use of closely held REITs. In order to meet the 100 or more shareholder requirement, the 84 REIT generally issues common stock, which is held by one shareholder, and a separate class of non-voting preferred stock with a relatively nominal value, which is held by 99 ‘‘friendly’’ shareholders. The closely held limitation does not disqualify the REITs that are utilizing this ownership structure because the majority shareholders of these REITs are not individuals. The Administration proposes to impose as an additional requirement for REIT qualification that no person can own stock of a REIT possessing 50 percent or more of the total combined voting power of all classes of voting stock or 50 percent or more of the total value of all shares of all classes of stock. For purposes of determining a person’s stock ownership, rules similar to the attribution rules contained in section 856(d)(5) would apply. The proposal would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action. Impose excise tax on purchase of structured settlements.—Current law facilitates the use of structured personal injury settlements because recipients of annuities under these settlements are less likely than recipients of lump sum awards to consume their awards too quickly and require public assistance. Consistent with that policy, this favorable treatment is conditional upon a requirement that the periodic payments cannot be accelerated, deferred, increased or decreased by the injured person. Nonetheless, certain factoring companies are able to purchase a portion of the annuities from the recipients for heavily discounted lump sums. These purchases are inconsistent with the policy underlying favorable tax treatment of structured settlements. Accordingly, the Administration proposes to impose on any person who purchases (or otherwise acquires for consideration) a structured settlement payment stream, a 40-percent excise tax on the difference between the amount paid by the purchaser to the injured person and the undiscounted value of the purchased payment stream unless such purchase is pursuant to a court order finding that the extraordinary and unanticipated needs of the original intended recipient render such a transaction desirable. The proposal would apply to purchases occurring on or after the date of enactment. No inference is intended as to the contractual validity of the purchase or the effect of the purchase transaction on the tax treatment of any party other than the purchaser. Amend 80/20 company rules.—Interest or dividends paid by a so-called ‘‘80/20 company’’ generally are partially or fully exempt from U.S. withholding tax. A U.S. corporation is treated as an 80/20 company if at least 80 percent of the gross income of the corporation for the three-year period preceding the year of a dividend is foreign source income attributable to the active conduct of a foreign trade or business (or the foreign business of a subsidiary). Certain foreign multinationals improperly seek to exploit the rules applicable to 80/ 20 companies in order to avoid U.S. withholding tax liability on earnings of U.S. subsidiaries that are dis- ANALYTICAL PERSPECTIVES tributed abroad. The proposal would prevent taxpayers from avoiding withholding tax through manipulations of these rules. The proposal would apply to interest or dividends paid or accrued on or after the date of enactment. Modify foreign office material participation exception applicable to inventory sales attributable to nonresident’s U.S. office.—In the case of a sale of inventory property that is attributable to a nonresident’s office or other fixed place of business within the United States, the sales income is generally U.S. source. The income is foreign source, however, if the inventory is sold for use, disposition, or consumption outside the United States and the nonresident’s foreign office or other fixed place of business materially participates in the sale. The proposal would provide that the foreign source exception shall apply only if an income tax equal to at least 10 percent of the income from the sale is actually paid to a foreign country with respect to such income. The proposal thereby ensures that the United States does not cede its jurisdiction to tax such sales unless the income from the sale is actually taxed by a foreign country at some minimal level. The proposal would be effective for transactions occurring on or after the date of enactment. Stop abuse of controlled foreign corporation (CFC) exception to ownership requirements of section 883.—Under section 887, a foreign corporation is subject to a four-percent tax on its United States source gross transportation income. Under section 883, however, the tax will not apply if the corporation is organized in a country (an ‘‘exemption country’’) that grants an equivalent tax exemption to U.S. shipping companies. The exemption from the four-percent tax is subject to an anti-abuse rule that requires at least 50 percent of the stock of the corporation be owned by individual residents of an exemption country. Thus, residents of a non-exemption country cannot secure the exemption simply by forming their shipping corporation in an exemption country. The anti-abuse rule requiring exemption country ownership does not apply, however, if the corporation is a controlled foreign corporation (the ‘‘CFC exception’’). The premise for the CFC exception is that the U.S. shareholders of a CFC will be subject to current U.S. income taxation on their share of the foreign corporation’s shipping income and, thus, the four-percent tax should not apply if the corporation is organized in an exemption country. Residents of non-exemption countries, however, can achieve CFC status for their shipping companies simply by owning the corporations through U.S. partnerships. Non-exemption country individuals can thereby avoid the anti-abuse rule requiring exemption country ownership and illegitimately secure the exemption from the four-percent U.S. tax. The proposal would stop that abuse. It would be effective for taxable years beginning on or after the date of enactment. 3. FEDERAL RECEIPTS Include qualified terminable interest property (QTIP) trust assets in surviving spouse’s estate.— A marital deduction is allowed for qualified terminable interest property (QTIP) passing to a qualifying trust for a spouse either by gift or by bequest. The value of the recipient spouse’s estate includes the value of any such property in which the decedent had a qualifying income interest for life and a deduction was allowed under the gift or estate tax. In some cases, taxpayers have attempted to whipsaw the government by claiming the deduction in the first estate and then arguing against inclusion in the second estate due to some technical flaw in the QTIP election. The Administration proposes that, if a deduction is allowed under the QTIP provisions, inclusion is required in the beneficiary spouse’s estate. The proposal would be effective for decedents dying after the date of enactment. Eliminate non-business valuation discounts.— Under current law, taxpayers are claiming large discounts on the valuation of gifts and bequests of interests in entities holding marketable assets. Because these discounts are inappropriate, the Administration proposes to eliminate valuation discounts except as they apply to active businesses. Interests in entities generally would be required to be valued for gift and estate tax purposes at a proportional share of the net asset value of the entity to the extent that the entity holds non-business assets. The proposal would be effective for gifts made after, and decedents dying after, the date of enactment. Eliminate gift tax exemption for personal residence trusts.—Current law excepts transfers of personal residences in trust from the special valuation rules applicable when a grantor retains an interest in a trust. The Administration proposes to repeal this personal residence trust exception. Thereafter, if a residence is to be used to fund a grantor retained interest trust, the trust would be required to pay out the required annuity or unitrust amount or else the grantor’s retained interest would be valued at zero for gift tax purposes. This proposal would be effective for transfers in trust after the date of enactment. Increase the proration percentage for property casualty (P&C) insurance companies.—In computing their underwriting income, P&C insurance companies deduct reserves for losses and loss expenses incurred. These loss reserves are funded in part with the company’s investment income. In 1986, Congress reduced the reserve deductions of P&C insurance companies by 15 percent of the tax-exempt interest or the deductible portion of certain dividends received. In 1997, Congress expanded the 15-percent proration rule to apply to the inside buildup on certain insurance contracts. The existing 15-percent proration rule still enables P&C insurance companies to fund a substantial portion of their deductible reserves with tax-exempt or tax-deferred income. Other financial intermediaries, such as life insurance companies, banks and brokerage 85 firms, are subject to more stringent proration rules that substantially reduce or eliminate their ability to use tax-exempt or tax-deferred investments to fund currently deductible reserves or deductible interest expense. Effective for taxable years beginning after the date of enactment, with respect to investments acquired on or after the date of first committee action, the Administration proposes to increase the proration percentage to 25 percent. OTHER PROVISIONS THAT AFFECT RECEIPTS Reinstate environmental tax imposed on corporate taxable income and deposited in the Hazardous Substance Superfund Trust Fund.—Under prior law, a tax equal to 0.12 percent of alternative minimum taxable income (with certain modifications) in excess of $2 million was levied on all corporations and deposited in the Hazardous Substance Superfund Trust Fund. The Administration proposes to reinstate this tax, which expired on December 31, 1995, for taxable years beginning after December 31, 1998 and before January 1, 2010. Reinstate excise taxes deposited in the Hazardous Substance Superfund Trust Fund.—The excise taxes that were levied on petroleum, chemicals, and imported substances and deposited in the Hazardous Substance Superfund Trust Fund are proposed to be reinstated for the period after the date of enactment and before October 1, 2009. These taxes expired on December 31, 1995. Convert a portion of the excise taxes deposited in the Airport and Airway Trust Fund to costbased user fees assessed for Federal Aviation Administration (FAA) services.—The excise taxes that are levied on domestic air passenger tickets and flight segments, international departures and arrivals, and domestic air cargo are proposed to be reduced over time as more efficient, cost-based user fees for air traffic services are phased in beginning in fiscal year 2000. The excise taxes are proposed to be reduced as necessary to ensure that the amount collected each year from the new user fees and the excise taxes together is equal to the total budget resources requested for the FAA in each succeeding year. Receipts from tobacco legislation.—The Administration includes receipts from tobacco legislation in the 2000 budget. These receipts, which total approximately $34 billion for the five years 2000 through 2004, would provide reimbursements for tobacco-related health care costs. Assess fees for examination of bank holding companies and State-chartered member banks (receipt effect).—The Administration proposes to require the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) to assess fees for the examination of bank holding companies and State-chartered banks. The Federal Reserve currently funds the costs of such 86 ANALYTICAL PERSPECTIVES examinations from earnings; therefore, deposits of earnings by the Federal Reserve, which are classified as governmental receipts, will increase by the amount of the fees. Restore premiums for the United Mine Workers of America Combined Benefit Fund.—The Administration proposes legislation to restore the previous calculation of premiums charged to coal companies that employed the retired miners that have been assigned to them. By reversing the court decision of National Coal v. Chater, this legislation will restore a premium calculation that supports medical cost containment. Assess mortgage transaction fees for flood hazard determination.—The Administration proposes to establish a $15 fee on mortgage originations and refinancings to support a multi-year program to update and modernize FEMA’s inventory of floodplain maps (100,000 maps). Accurate and easy to use flood hazard maps are essential in determining if a property is located in a floodplain. The maps allow lenders to meet their statutory obligation of requiring risk-prone homes with a mortgage to carry flood insurance, and allow homeowners to assess their risk of flood damage. These maps are the basis for developing appropriate riskbased flood insurance premium charges, and improved maps will result in a more actuarially sound insurance program. Replace Harbor Maintenance Tax with the Harbor Services User Fee (receipt effect).—The Administration proposes to replace the ad valorem Harbor Table 3–3. Maintenance Tax with a cost-based user fee, the Harbor Services User Fee. The user fee will finance harbor construction, operation, and maintenance activities performed by the Army Corps of Engineers, the costs of operating and maintaining the Saint Lawrence Seaway, and the costs of administering the fee. The fee will raise an average of $980 million annually through FY 2004, which is less than would have been raised by the Harbor Maintenance Tax before the Supreme Court decision that the ad valorem tax on exports was unconstitutional. Allow members of the clergy to revoke exemption from Social Security and Medicare coverage.— Under current law, ministers of a church who are opposed to participating in the Social Security and Medicare programs on religious principles may reject coverage by filing with the Internal Revenue Service before the tax filing date for their second year of work in the ministry. This proposal would provide an opportunity for members of the clergy to revoke their exemptions from Social Security and Medicare coverage. Create solvency incentive for State Unemployment Trust Fund accounts.—The Administration proposes to create an incentive for States to improve the solvency of their State accounts in the Federal Unemployment Trust Fund. This is intended to improve the ability of States to continue paying benefits in the event of a recession. The incentive consists of tying a portion of the projected distributions to the States under the Reed Act to demonstrated improvements in solvency. EFFECT OF PROPOSALS ON RECEIPTS (In millions of dollars) Estimate 1999 2000 2001 2002 2003 2004 2000–2004 Provide tax relief and extend expiring provisions: Make health care more affordable: Provide tax relief for long-term care needs .................................................................................. Provide tax relief for workers with disabilities ............................................................................... Provide tax relief to encourage small business health plans ....................................................... .............. .............. .............. –52 –21 –1 –1,107 –151 –5 –1,144 –169 –10 –1,312 –187 –15 –1,408 –196 –13 –5,023 –724 –44 Subtotal, make health care more affordable ............................................................................ .............. –74 –1,263 –1,323 –1,514 –1,617 –5,791 Expand education initiatives: Provide incentives for public school construction and modernization .......................................... Extend employer-provided educational assistance and include graduate education .................. Provide tax credit for workplace literacy and basic education programs .................................... Encourage sponsorship of qualified zone academies .................................................................. Eliminate 60-month limit on student loan interest deduction ........................................................ Eliminate tax when forgiving student loans subject to income contingent repayment ................ Provide tax relief for participants in certain Federal education programs ................................... .............. –72 .............. .............. .............. .............. .............. –146 –267 –3 –22 –18 .............. –3 –570 –719 –18 –43 –61 .............. –7 –939 –236 –25 –55 –62 .............. –7 –1,035 .............. –38 –24 –67 .............. –7 –1,045 .............. –55 .............. –73 .............. –6 –3,735 –1,222 –139 –144 –281 ................ –30 Subtotal, expand education initiatives ....................................................................................... –72 –459 –1,418 –1,324 –1,171 –1,179 –5,551 Make child care more affordable: Increase, expand, and simplify child and dependent care tax credit .......................................... Provide tax incentives for employer-provided child-care facilities ................................................ .............. .............. –338 –40 –1,585 –84 –1,426 –114 –1,471 –131 –1,503 –140 –6,323 –509 Subtotal, make child care more affordable ............................................................................... .............. –378 –1,669 –1,540 –1,602 –1,643 –6,832 3. 87 FEDERAL RECEIPTS Table 3–3. EFFECT OF PROPOSALS ON RECEIPTS—Continued (In millions of dollars) Estimate 1999 2000 2001 2002 2003 2004 2000–2004 Provide incentives to revitalize communities: Increase low-income housing tax credit per capita cap ............................................................... Provide Better America Bonds to improve the environment ........................................................ Provide New Markets Tax Credit .................................................................................................. Expand tax incentives for SSBICs ................................................................................................ Extend wage credit for two new EZs ............................................................................................ .............. .............. .............. –* .............. –46 –8 –12 –* .............. –186 –49 –88 –* .............. –330 –127 –207 –* .............. –474 –205 –297 –* .............. –620 –284 –376 –* .............. –1,656 –673 –980 –* ................ Subtotal, provide incentives to revitalize communities ............................................................. .............. –66 –323 –664 –976 –1,280 –3,309 Promote energy efficiency and improve the environment: Provide tax credit for energy-efficient building equipment ............................................................ Provide tax credit for new energy-efficient homes ....................................................................... Extend electric vehicle tax credit; provide tax credit for fuel-efficient vehicles ........................... Provide investment tax credit for CHP systems ........................................................................... Provide tax credit for rooftop solar systems ................................................................................. Extend wind and biomass tax credit and expand eligible biomass sources ............................... .............. .............. .............. –1 .............. .............. –230 –60 .............. –64 –9 –20 –407 –109 .............. –99 –19 –48 –376 –92 –4 –110 –25 –73 –393 –72 –178 –52 –34 –88 –127 –96 –712 –7 –45 –94 –1,533 –429 –894 –332 –132 –323 Subtotal, promote energy efficiency and improve the environment ......................................... –1 –383 –682 –680 –817 –1,081 –3,643 Promote expanded retirement savings, security and portability ....................................................... –27 –144 –204 –218 –213 –218 –997 Extend expiring provisions: Allow personal tax credits against the AMT ................................................................................. Extend work opportunity tax credit ................................................................................................ Extend welfare-to-work tax credit .................................................................................................. Extend R&E tax credit .................................................................................................................... Make permanent the expensing of brownfields remediation costs .............................................. Extend tax credit for first-time DC homebuyers ............................................................................ –67 –23 –3 –311 .............. 1 –679 –116 –19 –933 .............. –1 –707 –164 –36 –656 –106 –10 .............. –81 –21 –281 –170 –1 .............. –38 –9 –133 –168 .............. .............. –16 –2 –53 –167 .............. –1,386 –415 –87 –2,056 –611 –12 Subtotal, extend expiring provisions .......................................................................................... –403 –1,748 –1,679 –554 –348 –238 –4,567 Simplify the tax laws .......................................................................................................................... –64 –141 –159 –154 –104 –41 –599 Miscellaneous provisions: Make first $2,000 of severance pay exempt from income tax ..................................................... Allow steel companies to carryback NOLs up to five years ........................................................ .............. –19 –42 –190 –168 –28 –173 –30 –133 –24 .............. –20 –516 –292 Subtotal, miscellaneous provisions ............................................................................................ –19 –232 –196 –203 –157 –20 –808 Electricity restructuring: Deny tax-exempt status for new electric utility bonds except for distribution related expenses; repeal cost of service limitation for determining deductible contributions to nuclear decommissioning funds ........................................................................................................................ .............. 4 11 20 30 41 106 Subtotal, electricity restructuring ................................................................................................ .............. 4 11 20 30 41 106 Modify international trade provisions: Extend and modify Puerto Rico economic-activity tax credit ....................................................... Extend GSP and modify other trade provisions 1 ......................................................................... Levy tariff on certain textiles/apparel produced in the CNMI 1 ..................................................... Expand Virgin Island tariff credits 1 ............................................................................................... .............. –84 .............. .............. –24 –484 .............. .............. –46 –223 187 –* –71 –93 187 –* –106 –96 187 –2 –141 –99 187 –1 –388 –995 748 –3 Subtotal, modify international trade provisions ......................................................................... –84 –508 –82 23 –17 –54 –638 Subtotal, provide tax relief and extend expiring provisions .................................................. –670 –4,129 –7,664 –6,617 –6,889 –7,330 –32,629 Eliminate unwarranted benefits and adopt other revenue measures: Limit benefits of corporate tax shelter transactions: Deny tax benefits resulting from non-economic transactions; modify substantial understatement penalty for corporate tax shelters; deny deductions for certain tax advice and impose excise taxes on certain fees, rescission provisions and provisions guaranteeing tax benefits ............................................................................................................................................... Preclude taxpayers from taking tax positions inconsistent with the form of their transactions .. Tax income from corporate tax shelters involving tax-indifferent parties .................................... Require accrual of income on forward sale of corporate stock ................................................... Modify treatment of built-in losses and other attribute trafficking ................................................ Modify treatment of ESOP as S corporation shareholder ............................................................ Prevent serial liquidation of U.S. subsidiaries of foreign corporations ........................................ Prevent capital gains avoidance through basis shift transactions involving foreign shareholders ............................................................................................................................................... Limit inappropriate tax benefits for lessors of tax-exempt use property ...................................... Prevent mismatching of deductions and income exclusions in transactions with related foreign persons ....................................................................................................................................... .............. 5 15 1 9 17 .............. 11 50 150 4 113 64 12 76 52 155 9 185 102 20 162 55 165 13 192 145 19 194 58 175 21 200 183 19 214 62 185 31 208 202 19 657 277 830 78 898 696 89 65 1 301 35 114 79 64 119 45 147 27 163 551 543 .............. 60 104 108 112 117 501 88 ANALYTICAL PERSPECTIVES Table 3–3. EFFECT OF PROPOSALS ON RECEIPTS—Continued (In millions of dollars) Estimate 1999 2000 2001 2002 2003 2004 2000–2004 Restrict basis creation through Section 357(c) ............................................................................. Modify anti-abuse rule related to assumption of liabilities ............................................................ Modify COLI rules .......................................................................................................................... 3 1 .............. 9 2 240 19 4 366 28 5 398 39 7 427 50 9 451 145 27 1,882 Subtotal, limit benefits of corporate tax shelter transactions ................................................... 117 1,051 1,285 1,473 1,627 1,738 7,174 .............. 3 72 7 2 11 3 15 4 20 4 25 85 78 19 1 15 16 7 40 30 5 76 40 18 105 37 9 109 50 22 128 32 14 108 48 22 127 32 20 107 47 21 127 35 26 106 49 21 127 166 74 506 234 104 614 2 14 –28 6 .............. 16 .............. .............. 9 .............. .............. .............. .............. .............. .............. 3 .............. .............. 66 42 131 94 685 88 25 –219 30 134 379 172 27 3 2 15 9 6 83 55 162 64 757 124 39 –189 49 222 977 294 61 8 3 33 15 6 86 59 173 65 438 130 40 48 61 219 946 309 66 13 4 46 16 6 90 63 162 67 114 137 42 255 69 217 914 325 72 17 5 59 16 6 95 67 147 70 16 143 21 435 75 215 880 341 76 22 6 72 17 7 420 286 775 360 2,010 622 167 330 284 1,007 4,096 1,441 302 63 20 225 73 31 .............. .............. .............. .............. .............. 42 1 92 5 7 2 12 156 3 7 2 12 159 3 7 2 13 150 3 7 2 14 149 3 7 50 52 706 17 35 .............. 18 2 .............. 26 4 4 4 422 9 .............. 254 13 11 11 525 20 .............. 256 26 17 11 431 32 .............. 257 38 23 12 433 44 .............. 261 52 28 12 201 55 .............. 264 66 33 50 2,012 160 ................ 1,292 195 112 .............. .............. .............. .............. .............. .............. .............. .............. 1 4 .............. 6 28 92 5 6 .............. 17 .............. 310 10 32 27 24 8 48 94 65 12 25 4 6 540 32 44 27 10 6 49 96 107 15 42 1 7 570 46 46 27 12 3 51 97 112 19 43 1 7 600 56 48 28 14 1 52 99 118 13 37 1 7 630 68 50 28 15 –2 53 478 407 65 147 24 27 2,650 212 220 137 75 16 253 1 .............. .............. .............. 7 4 .............. 206 10 9 2 425 10 7 2 443 11 5 2 477 11 5 2 494 49 30 8 2,045 Other proposals: Require banks to accrue interest on short-term obligations ......................................................... Require current accrual of market discount by accrual method taxpayers ................................. Limit conversion of character of income from constructive ownership transactions with respect to partnership interests .............................................................................................................. Modify rules for debt-financed portfolio stock ............................................................................... Modify and clarify certain rules relating to debt-for-debt exchanges ........................................... Modify and clarify straddle rules .................................................................................................... Conform control test for tax-free incorporations, distributions, and reorganizations ................... Tax issuance of tracking stock ...................................................................................................... Require consistent treatment and provide basis allocation rules for transfers of intangibles in certain nonrecognition transactions ........................................................................................... Modify tax treatment of downstream mergers .............................................................................. Modify partnership distribution rules .............................................................................................. Deny change in method treatment to tax-free formations ............................................................ Repeal installment method for accrual basis taxpayers ............................................................... Deny deduction for punitive damages ........................................................................................... Apply uniform capitalization rules to tollers ................................................................................... Provide consistent amortization periods for intangibles ................................................................ Clarify recovery period of utility grading costs .............................................................................. Require recapture of policyholder surplus accounts ..................................................................... Modify rules for capitalizing policy acquisition costs of life insurance companies ...................... Subject investment income of trade associations to tax .............................................................. Restore phaseout of unified credit for large estates .................................................................... Require consistent valuation for estate and income tax purposes .............................................. Require basis allocation for part sale/part gift transactions ......................................................... Conform treatment of surviving spouses in community property States ..................................... Expand section 864(c)(4)(B) to interest and dividend equivalents ............................................... Recapture overall foreign losses when CFC stock is disposed ................................................... Increase elective withholding rate for nonperiodic distributions from deferred compensation plans ........................................................................................................................................... Increase section 4973 excise tax for excess IRA contributions .................................................. Limit pre-funding of welfare benefits for 10 or more employer plans .......................................... Subject signing bonuses to employment taxes ............................................................................. Expand reporting of cancellation of indebtedness income ........................................................... Require taxpayers to include rental income of residence in income without regard to the period of rental ............................................................................................................................... Repeal lower-of-cost-or-market inventory accounting method ...................................................... Defer interest deduction and OID on certain convertible debt ..................................................... Modify deposit requirement for FUTA ........................................................................................... Reinstate Oil Spill Liability Trust Fund tax 1 ................................................................................. Deny DRD for certain preferred stock ........................................................................................... Disallow interest on debt allocable to tax-exempt obligations ...................................................... Repeal percentage depletion for non-fuel minerals mined on Federal and formerly Federal lands ........................................................................................................................................... Modify rules relating to foreign oil and gas extraction income .................................................... Increase penalties for failure to file correct information returns ................................................... Tighten the substantial understatement penalty for large corporations ....................................... Require withholding on certain gambling winnings ....................................................................... Simplify foster child definition under EITC .................................................................................... Replace sales-source rules with activity-based rules ................................................................... Repeal tax-free conversions of large C corporations into S corporations ................................... Eliminate the income recognition exception for accrual method service providers ..................... Modify structure of businesses indirectly conducted by REITs .................................................... Modify treatment of closely held REITs ........................................................................................ Impose excise tax on purchase of structured settlements ........................................................... Amend 80/20 company rules ......................................................................................................... Modify foreign office material participation exception applicable to inventory sales attributable to nonresident’s U.S. office ....................................................................................................... Stop abuse of CFC exception to ownership requirements of section 883 .................................. Include QTIP trust assets in surviving spouse’s estate ................................................................ Eliminate non-business valuation discounts .................................................................................. 3. 89 FEDERAL RECEIPTS Table 3–3. EFFECT OF PROPOSALS ON RECEIPTS—Continued (In millions of dollars) Estimate 1999 2000 2001 2002 2003 2004 2000–2004 Eliminate gift tax exemption for personal residence trusts ........................................................... Increase proration percentage for P&C insurance companies ..................................................... .............. .............. –1 –4 –1 49 –1 64 3 87 12 107 12 303 Subtotal, other proposals ........................................................................................................... 217 3,693 5,574 5,617 5,676 5,652 26,212 Subtotal, eliminate unwarranted benefits and adopt other revenue measures 1 ................ 334 4,744 6,859 7,090 7,303 7,390 33,386 Other provisions that affect receipts: Reinstate environmental tax on corporate taxable income 2 ............................................................ Reinstate Superfund excise taxes 1 ................................................................................................... Convert Airport and Airway Trust Fund taxes to a cost-based user fee system 1 .......................... Receipts from tobacco legislation 1 .................................................................................................... Assess fees for examination of bank holding companies and State-chartered member banks (receipt effect) 1 ................................................................................................................................... Restore premiums for United Mine Workers of America Combined Benefit Fund .......................... Assess mortgage transaction fees for flood hazard determination 1 ................................................ Replace Harbor Maintenance tax with the Harbor Services User Fee (receipt effect) 1 ................. Allow members of the clergy to revoke exemption from Social Security and Medicare coverage Create solvency incentive for State unemployment trust fund accounts 1 ....................................... .............. 109 .............. –77 794 738 1,122 7,987 460 747 1,184 7,105 463 756 1,091 6,589 476 766 1,007 6,418 481 778 910 6,400 2,674 3,785 5,314 34,499 .............. 8 .............. .............. .............. .............. 82 15 58 –472 5 224 86 14 59 –505 8 312 90 13 62 –541 10 96 94 12 65 –578 10 .............. 98 12 68 –619 11 .............. 450 66 312 –2,715 44 632 Subtotal, other provisions that affect receipts 1 ...................................................................... 40 10,553 9,470 8,629 8,270 8,139 45,061 Total effect of proposals 1 ................................................................................................................... –296 11,168 8,665 9,102 8,684 8,199 45,818 * $500,000 or less. 1 Net of income offsets. 2 Net of deductibility for income tax purposes. 90 ANALYTICAL PERSPECTIVES Table 3–4. RECEIPTS BY SOURCE (In millions of dollars) Source 1998 Actual Estimate 1999 2000 2001 2002 2003 Individual income taxes (federal funds): Existing law ............................................................................................................................. 828,586 Proposed Legislation (PAYGO) .......................................................................................... .................. Legislative proposal, discretionary offset ........................................................................... .................. 869,160 –144 –71 902,059 –1,484 –834 918,399 –5,181 –741 947,596 –4,277 –569 975,721 –4,516 –502 1,022,940 –4,727 –478 Total individual income taxes .................................................................................................. 828,586 868,945 899,741 912,477 942,750 970,703 1,017,735 Corporation income taxes: Federal funds: Existing law ......................................................................................................................... 188,598 Proposed Legislation (PAYGO) ..................................................................................... .................. Legislative proposal, discretionary offset ....................................................................... .................. 182,346 –123 –13 186,496 2,056 –418 192,604 3,452 –208 199,217 3,679 –171 207,884 3,837 –151 217,189 3,662 –138 182,210 188,134 195,848 202,725 211,570 220,713 Total Federal funds corporation income taxes ...................................................................... 188,598 2004 Trust funds: Hazardous substance superfund ........................................................................................ 79 .................. .................. .................. .................. .................. .................. Legislative proposal, discretionary offset ....................................................................... .................. .................. 1,222 707 713 732 740 Total corporation income taxes .............................................................................................. 188,677 182,210 189,356 Social insurance and retirement receipts (trust funds): Employment and general retirement: Old-age and survivors insurance (Off-budget) .................................................................. 358,784 383,176 398,777 Proposed Legislation (non-PAYGO) .............................................................................. .................. .................. 3 Disability insurance (Off-budget) ........................................................................................ 57,015 60,860 66,534 Proposed Legislation (non-PAYGO) .............................................................................. .................. .................. .................. Hospital insurance .............................................................................................................. 119,863 127,363 131,982 Proposed Legislation (PAYGO) ..................................................................................... .................. .................. 2 Railroad retirement: Social Security equivalent account ................................................................................ 1,769 1,685 1,720 Rail pension and supplemental annuity ........................................................................ 2,583 2,656 2,693 196,555 203,438 212,302 221,453 412,564 6 70,065 1 136,933 2 428,922 8 72,833 1 142,483 2 446,411 8 75,804 1 148,429 2 464,104 9 78,813 1 154,624 2 1,749 2,750 1,769 2,789 1,792 2,824 1,813 2,848 Total employment and general retirement ............................................................................. 540,014 575,740 601,711 624,070 648,807 675,271 702,214 On-budget ........................................................................................................................... Off-budget ........................................................................................................................... 124,215 415,799 131,704 444,036 136,397 465,314 141,434 482,636 147,043 501,764 153,047 522,224 159,287 542,927 Unemployment insurance: Deposits by States 1 .......................................................................................................... 21,047 22,208 23,464 24,689 26,165 25,934 26,371 Proposed Legislation (PAYGO) ..................................................................................... .................. .................. 280 390 120 .................. .................. 1 Federal unemployment receipts ...................................................................................... 6,369 6,446 6,536 6,557 6,650 6,699 6,773 Proposed Legislation (PAYGO) ..................................................................................... .................. .................. .................. .................. .................. .................. .................. Railroad unemployment receipts 1 ..................................................................................... 68 111 77 37 70 124 130 Total unemployment insurance ............................................................................................... 27,484 28,765 30,357 31,673 33,005 32,757 33,274 Other retirement: Federal employees’ retirement—employee share ............................................................. Non-Federal employees retirement 2 ................................................................................. 4,259 74 4,248 71 4,396 65 4,493 60 4,482 54 3,912 44 3,659 39 Total other retirement ............................................................................................................. 4,333 4,319 4,461 4,553 4,536 3,956 3,698 Total social insurance and retirement receipts .................................................................... 571,831 608,824 636,529 660,296 686,348 711,984 739,186 On-budget ................................................................................................................................ Off-budget ................................................................................................................................ 156,032 415,799 164,788 444,036 171,215 465,314 177,660 482,636 184,584 501,764 189,760 522,224 196,259 542,927 Excise taxes: Federal funds: Alcohol taxes ...................................................................................................................... 7,215 Tobacco taxes .................................................................................................................... 5,657 Legislative proposal, discretionary offset ....................................................................... .................. Transportation fuels tax ...................................................................................................... 589 Telephone and teletype services ....................................................................................... 4,910 Ozone depleting chemicals and products .......................................................................... 98 Other Federal fund excise taxes ........................................................................................ 3,196 7,240 5,028 185 811 5,213 52 –564 7,249 6,264 1,441 717 5,489 26 1,766 7,251 6,705 906 735 5,780 13 1,721 7,235 7,220 7,207 7,370 7,575 7,553 217 .................. .................. 720 739 746 6,097 6,439 6,801 3 .................. .................. 1,686 1,606 1,607 3. 91 FEDERAL RECEIPTS Table 3–4. RECEIPTS BY SOURCE—Continued (In millions of dollars) Source 1998 Actual Proposed Legislation (PAYGO) ..................................................................................... .................. Legislative proposal, discretionary offset ....................................................................... .................. Total Federal fund excise taxes ............................................................................................. Trust funds: Highway ............................................................................................................................... Airport and airway .............................................................................................................. Legislative proposal, discretionary offset ....................................................................... Aquatic resources ............................................................................................................... Black lung disability insurance ........................................................................................... Inland waterway .................................................................................................................. Hazardous substance superfund ........................................................................................ Legislative proposal, discretionary offset ....................................................................... Oil spill liability .................................................................................................................... Proposed Legislation (PAYGO) ..................................................................................... Vaccine injury compensation .............................................................................................. Leaking underground storage tank .................................................................................... 21,665 Estimate 1999 8 –381 17,592 2000 2001 2002 2003 2004 13 15 16 18 19 381 .................. .................. .................. .................. 23,346 23,126 23,344 23,597 23,933 26,628 38,464 33,097 33,642 34,252 34,890 35,539 8,111 10,397 9,251 9,693 10,441 11,060 11,736 .................. .................. 1,496 1,579 1,455 1,341 1,214 290 376 334 340 377 381 398 636 638 656 674 690 705 720 91 102 105 107 109 111 113 .................. .................. .................. .................. .................. .................. .................. .................. 147 985 996 1,008 1,022 1,037 .................. .................. .................. .................. .................. .................. .................. .................. 35 339 341 344 348 351 116 112 113 114 116 116 117 136 212 180 183 187 190 194 Total trust funds excise taxes ................................................................................................ 36,008 50,483 46,556 47,669 48,979 50,164 51,419 Total excise taxes ..................................................................................................................... 57,673 68,075 69,902 70,795 72,323 73,761 75,352 Estate and gift taxes: Federal funds .......................................................................................................................... 24,076 25,932 Proposed Legislation (PAYGO) .......................................................................................... .................. .................. 26,740 232 27,880 487 29,979 510 31,046 554 33,318 584 Total estate and gift taxes ....................................................................................................... 25,932 26,972 28,367 30,489 31,600 33,902 Customs duties: Federal funds .......................................................................................................................... 17,585 17,110 Proposed Legislation (PAYGO) .......................................................................................... .................. –112 Trust funds .............................................................................................................................. 712 656 Legislative proposal, discretionary offset ........................................................................... .................. .................. 18,941 –645 697 –629 19,953 –48 744 –674 21,219 125 792 –721 22,767 119 844 –771 24,663 115 901 –825 Total customs duties ................................................................................................................ 17,654 18,364 19,975 21,415 22,959 24,854 112 120 .................. 165 340 281 .................. 8 24,540 26,354 .................. .................. .................. 6 5,560 5,629 .................. .................. 1,925 1,962 222 206 –41 –37 123 6,525 291 15 25,121 110 6 7,752 78 1,963 181 –37 126 6,426 282 14 26,008 115 6 9,713 80 1,984 134 –37 128 6,426 275 13 26,941 120 6 14,244 83 1,968 128 –37 131 6,418 270 12 27,973 125 6 14,620 87 1,977 131 –37 134 6,400 263 12 28,896 130 6 15,033 91 1,988 129 –37 MISCELLANEOUS RECEIPTS: 3 Miscellaneous taxes ................................................................................................................ Receipts from tobacco legislation (discretionary offset) ........................................................ United Mine Workers of America combined benefit fund ..................................................... Proposed Legislation (PAYGO) .......................................................................................... Deposit of earnings, Federal Reserve System ...................................................................... Proposed Legislation (PAYGO) .......................................................................................... Defense cooperation ............................................................................................................... Fees for permits and regulatory and judicial services .......................................................... Proposed Legislation (PAYGO) .......................................................................................... Fines, penalties, and forfeitures ............................................................................................. Gifts and contributions ............................................................................................................ Refunds and recoveries .......................................................................................................... 24,076 18,297 Total miscellaneous receipts ................................................................................................... 32,658 34,694 42,128 44,851 50,295 51,713 53,045 Total budget receipts ................................................................................................................ On-budget ................................................................................................................................ Off-budget ................................................................................................................................ 1,721,798 1,305,999 415,799 1,806,334 1,362,298 444,036 1,882,992 1,417,678 465,314 1,933,316 1,450,680 482,636 2,007,058 1,505,294 501,764 2,075,022 1,552,798 522,224 2,165,527 1,622,600 542,927 MEMORANDUM Federal funds .......................................................................................................................... Trust funds .............................................................................................................................. Interfund transactions .............................................................................................................. 1,113,467 385,631 –193,099 1,146,637 413,274 –197,613 1,200,714 426,370 –209,406 1,224,894 443,257 –217,471 1,271,291 461,895 –227,892 1,312,435 479,001 –238,638 1,374,499 496,908 –248,807 Total on-budget ......................................................................................................................... 1,305,999 1,362,298 1,417,678 1,450,680 1,505,294 1,552,798 1,622,600 Off-budget (trust funds) ............................................................................................................ 415,799 444,036 465,314 482,636 501,764 522,224 542,927 92 ANALYTICAL PERSPECTIVES Table 3–4. RECEIPTS BY SOURCE—Continued (In millions of dollars) Source Total ............................................................................................................................................. 1 Estimate 1998 Actual 1999 2000 2001 2002 2003 2004 1,721,798 1,806,334 1,882,992 1,933,316 2,007,058 2,075,022 2,165,527 Deposits by States cover the benefit part of the program. Federal unemployment receipts cover administrative costs at both the Federal and State levels. Railroad unemployment receipts cover both the benefits and adminstrative costs of the program for the railroads. 2 Represents employer and employee contributions to the civil service retirement and disability fund for covered employees of Government-sponsored, privately owned enterprises and the District of Columbia municipal government. 3 Includes both Federal and trust funds. 4. USER FEES AND OTHER COLLECTIONS The Federal Government sometimes charges user fees to those who directly benefit from a particular activity. The term ‘‘user fee’’ is defined as fees, charged, and assessments levied on a class directly benefitting from, or subject to regulation by, a government program or activity, to be utilized solely to support the program or activity. In addition, the payers of the fee must be limited to those benefitting from, or subject to regulation by, the program or activity, and may not include the general public or a broad segment of the public. The user fee must be authorized for use only to fund the specified programs or activities for which they are charged, including directly associated agency functions, not for unrelated programs or activities and not for the broad purposes of the Government or an agency. User fees include: collections from non-Federal sources for goods and services provided (such as the sale of postage stamps and electricity); voluntary payments to social insurance programs (such as Medicare Part B premiums); miscellaneous customs fees (such as United States Customs Service merchandise processing fees); and certain specific taxes and duties (such as collections for agricultural quarantine inspection). The term ‘‘user fee’’ is not a separate budget category for collections. Depending primarily on whether the user charge is based on the Government’s sovereign power or business-type activity, it may be classified as a governmental receipt, or as an offsetting collection. User fees classified as governmental receipts are included along with the taxes and other governmental receipts discussed in the previous chapter. Those fees classified as offsetting collections are subtracted from gross outlays. The purpose of this treatment is to produce budget totals for receipts, outlays, and budget authority in terms of the amount of resources allocated governmentally, through collective political choice rather than through the market. Offsetting collections are classified into two major categories: offsetting receipts, which are deposited in receipt accounts; and offsetting collections credited to appropriations (expenditure) accounts, which are deposited directly in these accounts and usually can be spent without further action by the Congress. Both categories include collections from other accounts within the Government as well as the public. While most offsetting receipts and collections result from business-like activity or are collected from other Government accounts, some result from the Government’s sovereign or governmental powers and would be classified as governmental receipts but are required by law to be treated as offsetting. Chapter 23, ‘‘Budget System and Concepts,’’ explains the budgetary treatment of these collections more fully. Not all offsetting collections are user fees. User fees do not include collections from other Federal accounts; collections deposited in general fund receipt accounts; collections associated with credit programs; realizations upon loans and investments; interest, dividends, and other earnings; involuntary payments to social insurance programs; excise taxes; customs duties; fines, penalties, and forfeitures; cost sharing contributions; proceeds from asset sales (property, plant, and equipment); Outer Continental Shelf receipts; spectrum auction proceeds; and Federal Reserve earnings. As shown in Table 4–1, total user fee collections (including those proposed in this budget) are estimated to be $146.9 billion in 2000, rising to $170.1 billion in 2004. User fee collections by the United States Postal Service, Medicare premiums, service charges on foreign military sales, the Tennessee Valley Authority and other power marketing agencies, and fees collected by the Department of Defense at commissaries, for housing, and for other miscellaneous activities are estimated to be nearly 80 percent of all existing user fee collections. User fee collections are used to offset outlays in both the discretionary and mandatory categories of the budget. User fee collections are estimated to provide $17.4 billion to offset discretionary spending. These offsets include both offsetting collections credited directly to appropriations accounts and collections credited to offsetting receipt accounts. The Administration is proposing to augment offsetting collections available for discretionary spending by making collections from Federal Aviation Administration (FAA) cost-based user fees and the new harbor services fee, approximately $2.1 billion, available for discretionary spending. Mandatory user fee collections are estimated to provide $127.4 billion in 2000. Of this amount, approximately $126.5 billion offsets mandatory outlays, while the remaining collections, from the Harbor Services fee, would be made available to offset discretionary spending. A small portion of governmental receipts are considered to be user fee collections. In 2000, an estimated $2.1 billion in governmental receipts are user fees. Of these fees, about 72 percent are part of the proposal that would make FAA’s cost-based user fees available to offset discretionary spending. The remaining fees in this category are made available to finance the regulatory program or activity for which they are charged through the appropriations process. Table 4–3 provides more detail for offsetting receipts collected from the public and includes offsetting receipts collected from other accounts within the Government. 93 94 ANALYTICAL PERSPECTIVES Table 4–1. TOTAL USER FEE COLLECTIONS (In millions of dollars) Estimates 1998 actual 1999 2000 2001 2002 2003 2004 Total 1999–2004 Governmental receipts: Proposed FAA user fees to replace excise taxes 1 ..................................................... Harbor maintenance and inland waterway fees 2 ......................................................... Agricultural quarantine inspection fees ........................................................................ FEMA, flood map modernization .................................................................................. Other governmental receipt user fees ......................................................................... .............. 622 152 .............. 223 .............. 588 160 .............. 244 1,496 .............. 219 78 295 1,579 .............. 232 80 298 1,455 .............. 239 83 303 1,341 .............. 246 87 304 1,214 .............. 253 91 308 7,085 588 1,349 419 1,508 Total, governmental receipts ..................................................................................... 997 992 2,088 2,189 2,080 1,978 1,866 10,201 7,594 7,313 7,253 7,255 7,239 7,239 7,239 43,538 814 682 858 863 870 838 870 838 870 838 870 838 870 838 5,208 5,053 Offsetting collections by function and category: Discretionary National Defense, Housing and commissary fees paid by military personnel and other fees ................................................................................................................... Energy, Nuclear Regulatory Commission, Federal Energy Regulatory Commission and other fees ........................................................................................................... Science, Reimbursement for the use of NASA services ............................................ Commerce and Housing Credit, Patent and Trademark Office, Federal Communications Commission, Securities and Exchange Commission and other fees ...... Transportation, Panamal Canal and other fees ............................................................ Health, Food and Drug Administration, Health Care Financing Administration, food safety and other fees ................................................................................................ Veterans, medical care and other fees ....................................................................... Justice, Customs, bankruptcy and other fees ............................................................. General Government, Bureau of Engraving and Printing, U.S. Mint and IRS fees .. All other functions, discretionary ................................................................................... 1,754 884 1,703 896 1,931 434 1,914 558 1,906 558 1,893 558 1,829 558 11,176 3,562 404 700 259 1,573 753 400 641 283 1,821 944 1,202 765 771 1,848 1,444 1,202 929 771 1,848 1,448 1,202 1,146 771 1,848 1,449 1,202 1,153 771 1,848 1,451 1,202 1,179 771 1,848 1,453 6,410 5,813 4,138 11,061 8,189 Total discretionary offsetting collections ................................................................... 15,417 15,722 17,356 17,633 17,827 17,823 17,787 104,148 Mandatory International, Service charges on foreign military sales ............................................... Energy, Tennessee Valley Authority and other power marketing fees ....................... Natural resources and the environment: Harbor Services fees 2 ............................................................................................. Recreation and admission fees and other fees ...................................................... 14,135 10,046 13,280 8,951 12,690 9,136 12,140 9,332 12,050 9,325 9,720 9,531 8,610 9,795 68,490 56,070 .............. 649 966 629 963 651 960 661 996 697 1,014 706 4,899 724 4,068 Subtotal, Natural resources and environmental fees ........................................... 649 629 1,617 1,624 1,657 1,702 1,738 8,967 Agriculture, Crop insurance premiums, inspection, grading and other fees ................ Commerce and Housing Credit:. United States Postal Service .................................................................................... Deposit Insurance and other fees ............................................................................. 801 1,080 1,125 1,166 1,200 1,240 1,285 7,096 59,757 900 62,639 698 65,036 834 67,900 944 71,000 1,075 74,000 1,353 77,000 1,690 417,575 6,594 Subtotal, Commerce and housing credit .............................................................. 60,657 63,337 65,870 68,844 72,075 75,353 78,713 424,192 Community development, Flood insurance and other fees .......................................... Health, Federal Employee Health Benefits and other fees .......................................... Medicare premiums ........................................................................................................ Income Maintenance, Pension Benefit Guaranty Corporation, Federal employees life insurance premiums ............................................................................................ Veterans, Insurance premiums and other fees ........................................................... Justice, Immigration, Customs and other justice fees .................................................. All other functions, mandatory ..................................................................................... 1,355 4,492 20,747 1,461 4,845 21,299 1,560 5,489 22,834 1,666 6,011 25,279 1,773 6,519 27,615 1,887 7,066 30,647 2,018 7,585 32,939 10,365 37,515 160,613 1,930 1,739 2,430 406 1,965 1,706 2,542 455 2,163 1,683 2,794 1,424 2,331 1,643 2,837 1,428 2,461 1,603 2,895 1,414 2,601 1,566 2,976 1,452 2,733 1,525 3,039 1,496 14,254 9,726 17,083 7,669 Total mandatory offsetting collections ....................................................................... 119,387 121,550 127,419 133,338 139,627 144,745 150,439 817,118 Total offsetting collections ............................................................................................. 134,804 137,272 144,775 150,971 157,454 162,568 168,226 921,266 Total, User fees ................................................................................................................ 135,801 138,264 146,863 153,160 159,534 164,546 170,092 932,459 1 Gross revenue increase from proposed fees. Current aviation excise taxes, which are not user fees, will gradually be converted to cost-based user fees. While considered governmental receipts, the following proceeds from the fees, net of income tax offsets, would be made available to offset discretionary spending: FAA collections available for spending ................................................................................................................................................................................................... 2 1998 1999 ............ ............ 2000 2001 2002 2003 1,122 1,184 1,091 1,007 The Budget proposes to convert proceeds to offsetting collections. While the fee collection will be mandatory, proceeds from the fee will be made available to offset discretionary spending. 2004 910 1999–04 5,314 95 4. USER FEES AND OTHER COLLECTIONS Why User Fees? • • • • • • • • The term ‘‘user fee’’ refers to Government charges to those who use a Government good or service or are subject to Government regulation. For example: —Park entrance fees charged to visitors to national parks —Meat, poultry, and egg inspection fees —Tennessee Valley Authority proceeds from power sales —Proceeds from the lease of Department of Energy buildings and facilities —Flood insurance premiums —Sales of commemorative coins User fees are dedicated to funding part or all of the cost of providing the service or regulation by crediting them to a program account instead of to the general fund of the Treasury. User fees are designated as offsetting collections or receipts so that they offset the spending they are designated to fund. User fees are different from general revenue, because they are not collected from the general public or broad segments of the public (like income taxes) and they are not used for the general purposes of government (like national defense). Users are more willing to support and pay fees when they are dedicated to maintaining or improving the quality of the programs that affect them directly. Government program managers may be more diligent about collecting and spending fees when funding for their programs is dependent on fees, instead of guaranteed appropriations of general taxpayer money. Administration policy is to shift to user fee funding wherever appropriate. However, essential government services will continue to be supported by general fund appropriations from the Treasury as necessary. The Administration’s user fee proposals generally require authorizing legislation to authorize the fees first and appropriations action before the fees can actually be collected and spent. This is done to preserve the traditional roles of the authorizing and appropriations committees in Congress and to conform to the ‘‘scoring’’ conventions of the Budget Enforcement Act. The Budget contains a variety of new and expanded user fee and other collections proposals that would yield $4.2 billion in 2000 and $25.8 billion from 2000 through 2004. These proposals establish, increase, or extend fees in order to recover more of the costs of providing government services. The proposals, would make the program funding levels at least partly dependent on the amount of fees actually collected. Therefore, in many Table 4–2. cases, resources available for the program could be greater or less than estimated. Table 4–2 splits the proposals between discretionary and mandatory categories for the appropriate scoring under the Budget Enforcement Act of 1997 (BEA). It includes user fees classified as offsetting collections and governmental receipts. PROPOSED USER FEE COLLECTIONS (In millions of dollars) Discretionary fee proposals User Fee Proposals To Offset Discretionary Spending Offsetting collections deposited in appropriations accounts: Department of Agriculture: Food Safety Inspection Service fees ....................................................................................................................... Tobacco program support fees .................................................................................................................................. Animal and Plant Health Inspection Service fees ................................................................................................... Grain Inspection, Packers, and Stockyards fees .................................................................................................... Forest Service timber sales preparation fees .......................................................................................................... Department of Commerce: National Oceanic and Atmospheric Administration Navigational assistance fees .................................................. Fisheries management fees ..................................................................................................................................... Patent and Trademark Office, indirect health and life insurance cost fee ............................................................. International Trade Administration, trade promotion service fees .......................................................................... Department of Health and Human Services: Food and Drug Administration increased user fees ................................................................................................ Health Care Financing Administration fee proposals:. Physician, provider, and supplier enrollment registration fees ........................................................................... Managed care organization application and renewal fees ................................................................................. Initial provider certification fees ........................................................................................................................... Provider recertification fees .................................................................................................................................. Paper claims submission fees ............................................................................................................................. Duplicate and unprocessable claims fees ........................................................................................................... Increase Medicare+Choice fees ........................................................................................................................... Department of Justice: Increase Bankruptcy filing fee .................................................................................................................................. Department of Labor: Alien Labor Certification fees ................................................................................................................................... Employment Tax Credit fees .................................................................................................................................... Department of Transportation: Coast Guard, navigational services fees ................................................................................................................. 2000 2001 2002 2003 2004 2000–2004 504 60 9 19 20 504 60 9 19 20 504 60 9 19 20 504 60 9 19 20 504 60 9 19 20 2,520 300 45 95 100 14 20 20 3 14 20 20 3 14 20 20 3 14 20 20 3 14 20 20 3 70 100 100 15 17 17 17 17 17 85 20 37 10 55 55 18 50 20 37 10 55 110 36 50 20 37 10 55 110 36 50 20 37 10 55 110 36 50 20 37 10 55 110 36 50 100 185 50 275 495 162 250 28 28 28 28 28 140 65 20 65 20 65 20 65 20 65 20 325 100 41 165 165 165 165 701 96 ANALYTICAL PERSPECTIVES Table 4–2. PROPOSED USER FEE COLLECTIONS—Continued (In millions of dollars) Discretionary fee proposals Hazardous Material Transportation safety fee ......................................................................................................... Surface Transportation Board fees .......................................................................................................................... Department of the Treasury: Customs, air and sea passenger fee ...................................................................................................................... Customs, access fee .................................................................................................................................................. Army Corps of Engineers: Regulatory program fees .......................................................................................................................................... National Transportation Safety Board: Commercial accident investigation fees ................................................................................................................... 2000 2001 2002 2003 2004 2000–2004 18 14 18 14 18 14 18 14 18 14 90 70 312 163 312 163 312 163 312 163 312 163 1,560 815 7 7 7 7 7 35 10 10 10 10 10 50 1,608 1,806 1,806 1,806 1,806 8,833 88 88 88 88 88 440 10 10 10 10 10 50 4 16 8 16 8 16 8 16 8 16 36 80 200 200 200 200 200 1,000 300 300 300 300 300 1,500 19 19 19 19 19 95 637 641 641 641 641 3,201 1,496 1,579 1,455 1,341 1,214 7,085 337 296 245 231 248 1,357 Subtotal, mandatory collections available to offset discretionary ........................................................................ 1,833 1,875 1,700 1,572 1,462 8,442 Total, user fees to offset discretionary spending ........................................................................................................ 4,078 4,322 4,147 4,019 3,909 20,476 84 88 91 95 100 458 –135 275 482 560 686 1,868 ............ ............ 24 34 44 102 ............ 3 ............ 68 3 8 70 4 26 72 4 26 210 5 26 19 86 Subotal, Offsetting collections deposited in appropriations accounts .................................................................. Offsetting collections deposited in receipt accounts: Department of Transportation: Federal Railroad Administration, rail safety inspection fees ................................................................................... Department of Housing and Urban Development: Government Sponsored Enterprise (GSE) oversight fees ...................................................................................... Environmental Protection Agency: Pre-Manufacture Notice (PMN) fee .......................................................................................................................... Pesticide Registration Fees ...................................................................................................................................... Federal Communications Commission: Analog spectrum lease fee ....................................................................................................................................... Nuclear Regulatory Commission: Extend NRC user fees ............................................................................................................................................. Social Security Administration: Social Security Administration, claimant representative fees .................................................................................. Subotal, offsetting collections deposited in receipt accounts ............................................................................... Mandatory collections made available to offset discretionary spending: Department of Transportation: Federal Aviation Administration, proposed user fees 1 ........................................................................................... Army Corps of Engineers: Harbor Services Fees (Replacing Harbor Maintenance Tax 2 ................................................................................ User Fee Proposals to Offset Mandatory Spending Offsetting collections deposited in appropriations accounts: Federal Deposit Insurance Corporation: FDIC State Bank exam fees .................................................................................................................................... Offsetting collections deposited in receipt accounts: Department of Health and Human Services: Medicare Premiums .................................................................................................................................................... Department of Agriculture: Forest Service, increased recreation and entrance fees .......................................................................................... Department of the Interior: Increased recreation and entrance fees .................................................................................................................. Filming and special use permits ................................................................................................................................ Hardrock mining production fees ............................................................................................................................. Department of Justice: Increase Immigration user fee ................................................................................................................................... Department of the Treasury: Extend Customs conveyance and passenger fees ................................................................................................. Extend Customs merchandise processing fees ....................................................................................................... 121 128 135 142 150 676 ............ ............ ............ ............ ............ ............ ............ ............ 497 1,025 497 1,025 Subotal, offsetting collections deposited in receipt accounts ............................................................................... –11 414 739 836 2,505 4,483 Total, user fee proposals to offset mandatory spending ........................................................................................... 73 502 830 931 2,605 4,941 Collections deposited to governmental receipt accounts: Federal Emergency Management Agency: Mortgage transaction fees for flood plain certification 3 ............................................................................................ 75 76 77 78 80 386 4,226 4,900 5,054 5,028 6,594 25,803 Total, user fee proposals 1 Gross revenue increase from proposed fees. Current aviation excise taxes, which are not user fees, will gradually be converted to cost-based user fees. While considered governmental receipts, the following proceeds from the fees, net of income tax offsets, would be made available to offset discretionary spending: FAA collections available for spending ................................................................................................................................................................................................... 2 1998 1999 ............ ............ Collections shown for the Harbor Services user fee represent the increase in receipts over current law collections remaining after collections from exporters were halted. 3 Represents the gross revenue. Approximately $58 million would be available to spend in FY 2000. 2000 2001 2002 2003 1,122 1,184 1,091 1,007 2004 910 1999–04 5,314 4. USER FEES AND OTHER COLLECTIONS Discretionary offsetting collections: The following proposed fees are classified as discretionary because they would result from provisions in appropriations acts. In most cases, the Administration will propose authorizing legislation to establish, increase, or extend fees. However, the legislation will make both the fee collection and spending contingent on appropriations action, so that both can be scored as discretionary. The budget includes the appropriations language needed to trigger the fee collection. When the user fees are enacted, they will finance part or all of the cost of the affected programs in lieu of some amount of the general fund appropriation for the program. While the appropriations language proposed under current law includes the full amount of funding needed for the program, the trigger language would reduce that amount upon enactment of the fee authorization. (If general fund appropriations were not reduced, the total resources provided would exceed the funding requirements for the programs.) Collections from the following proposals are to be deposited directly in appropriations accounts: DEPARTMENT OF AGRICULTURE Food Safety and Inspection Service meat, poultry and egg inspection fee.—The 2000 Budget proposes a new user fee for the Department of Agriculture’s Food Safety and Inspection Service (FSIS). Under the proposed fee, the meat, poultry and egg industries would be required to reimburse the Federal government for the cost of the salaries and benefits and other direct costs for all in-plant inspection. The proposal would transfer the cost of Federal inspection services to the industries that directly benefit, and would ensure that sufficient resources are available to provide the level of in-plant inspection necessary to meet the demands of industry. The cost of the user fee would amount to less than one cent per pound of meat inspected. Tobacco program support fees.—The 2000 Budget proposes to extend and increase the marketing assessment on price supported tobacco and on similar imported tobacco. The current assessment equal to 1 percent of the support price expires with the 1998 crop year. The assessment on domestic tobacco is equally divided between producers and purchasers, while importers pay the entire assessment on imported tobacco. The proposal would extend the assessment to 2000 and thereafter at a rate of about two percent of the support price. The current rate of 0.5 percent of the support price paid by producers would be continued, while purchasers and importers would be assessed at an increased rate. The assessment would raise revenues equivalent to the estimated costs incurred by the Agriculture Department’s for activities that support the production and marketing of tobacco. Animal and Plant Health Inspection Service (APHIS).—The budget proposes to establish fees to cover the cost of providing animal welfare inspections to recipients of APHIS services such as animal research 97 centers, humane societies, and kennels. Fees would also be established to cover the cost of issuing biotechnology certificates to firms that manufacture products derived through biotechnological innovation. Grain Inspection, Packers and Stockyards Administration (GIPSA) licensing fees.—The budget proposes to charge the grain industry GIPSA’s costs to review and maintain standards (such as grain quality and classification) used by the grain industry. In addition, an annual licensing fee is proposed to fund GIPSA activities that ensure the integrity of the livestock, meat and poultry market and marketplace, such as fostering open competition, and protecting consumers and businesses from unfair practices. Forest Service, timber sales preparation fee pilot.— The Administration proposes to require timber companies to reimburse the Forest Service for the costs of timber sales preparation on National Forests. Timber purchasers would bear the direct costs for timber sales preparation (direct costs do not include legal and certain environmental planning costs) for commodity-oriented timber sales. DEPARTMENT OF COMMERCE National Oceanic and Atmospheric Administration (NOAA), navigational assistance fees.—The Administration proposes to levy a fee on U.S. and foreign commercial cargo carriers to recover the cost of navigational assistance services, such as nautical charting, provided by NOAA. Fisheries management fees.—The budget proposes to levy a fee to recover a portion of the costs of providing fisheries management and enforcement services. Patent and Trademark Office indirect cost fees.—The Administration proposes to increase Patent and Trademark Office fees to cover the costs associated with current PTO employees’ post-retirement health and life insurance. Under current law, the FY 2000 program level is expected to impose $20 million in future costs on the Federal Treasury. Collections from the fee increase would be transferred to the Office of Personnel Management. Trade promotion services fees.—The Administration proposes to charge U.S. businesses for counseling and other promotional services provided by the International Trade Administration. DEPARTMENT OF HEALTH AND HUMAN SERVICES Food and Drug Administration (FDA) fees.—The budget seeks $17 million in new fees to finance FDA activities for the review of medical device applications, food additive petitions, and pre-market notifications for food contact substances. These fees will be used to augment current funding for these activities. Health Care Financing Administration (HCFA).— These proposals would establish fees for a variety of activities associated with the Medicare Program, including: Physician, provider, and supplier enrollment registration fees.—The Administration proposes to charge phy- 98 sicians, providers, and suppliers an initial enrollment fee and a renewal fee in order to participate in the Medicare program. Physicians would be required to reenroll every 5 years. Durable medical equipment suppliers, hospitals, skilled nursing facilities, home health agencies, and all other providers would be required to re-enroll every 3 years. Proceeds from the fee would be used to offset Contractor funding related to enrollment costs. Managed care organization application and renewal fees.—The Administration proposes to charge managed care organizations a fee to cover the cost of reviewing initial applications and renewing annual contracts with Medicare. Proceeds from this fee would be used to offset Federal Administration funding related to managed care organization applications and renewals. Initial provider certification fee.—The Administration proposes to levy a fee on providers (e.g., home health agencies and skilled nursing facilities) who wish to enter the Medicare program. The fee would vary by type of provider. Proceeds from this fee would be used to offset survey and certification funding. Provider recertification fee.—The Administration proposes to levy a fee on providers who are recertified for the Medicare program. By statute, skilled nursing facilities must be surveyed every year, home health agencies every three years, and other providers about once every ten years. The fee would be charged every year to spread the costs of the certification program over time. Proceeds from this fee would be used to offset survey and certification funding. Paper claims submission fee.—The Administration proposes to charge providers $1.00 for every paper claim submitted for payment because of the additional cost of processing paper rather than electronic claims. Rural providers and very small providers who may not be able to purchase the necessary hardware to comply with electronic claims transmission would be exempt from the fee. Proceeds from the fee would be used to offset Contractor funding related to claims processing. Duplicate and unprocessable claims fees.—The Administration proposes to charge Medicare providers $1.00 for each duplicate and unprocessable claim submitted for payment to the Health Care Financing Administration. Proceeds from the fee would be used to offset Contractor funding related to claims processing. Increase in the Medicare+Choice fee.—The Administration proposes to increase the fee on Medicare+Choice plans by $50 million in FY 2000. The fee was authorized at $100 million in the Balanced Budget Act of 1997. This increase would be used to maintain the current level of effort in providing information to Medicare beneficiaries regarding the Medicare+Choice program. DEPARTMENT OF JUSTICE Bankruptcy filing fee.—The Administration proposes to increase the filing fee for cases filed under chapters 7 (liquidation) and 13 (wage earner repayment) of the Bankruptcy Code by $25, from $130 to $155, with the increased collections to be used by the U.S. Trustee ANALYTICAL PERSPECTIVES Program. This would allow the program to continue to be funded entirely through bankruptcy fees. The U.S. trustees supervise the administration of bankruptcy cases and private trustees in the Federal Bankruptcy Courts. The program currently receives $30 of the $130 filing fee. DEPARTMENT OF LABOR Alien labor certification fee.—The proposal would establish a new fee, charged to businesses, for processing of alien labor certification applications by the Department of Labor. The fee proceeds would offset the costs of administering and enforcing the alien labor program, and provide reemployment and training assistance to U.S. workers who have been dislocated from their jobs. Employment tax credit fees.—The proposal would establish a new fee, charged to businesses, for processing requests for certifications under the Work Opportunity Tax Credit and the Welfare-to-Work Tax Credit. These fees would be used to cover the State administrative costs of certifying the eligibility of new hires under these tax credits. DEPARTMENT OF TRANSPORTATION Coast Guard, navigational assistance fee.—The Administration proposes to levy a fee on U.S. and foreign commercial cargo carriers for the use of Coast Guard navigational assistance services. Navigational assistance services include the placement and maintenance of buoys and other short-range aids-to-navigation, radio navigation, and vessel traffic services. Fishing and recreational vessels would be exempt. Federal Railroad Administration, rail safety inspection fees.—This proposed would offset the costs of the Federal Railroad Administration’s safety inspection program. An estimated $88 million in fees would be collected from railroad carriers based upon a calculation of their rail usage. Hazardous Materials Transportation Safety fees.—Beginning late in 2000, hazardous materials transportation safety activities previously financed by general fund appropriations to the Research and Special Programs Administration are proposed to be financed instead by an increase in hazardous materials registration fees. Authorizing legislation will be proposed to increase the fees paid by shippers and carriers of hazardous materials by an estimated $18 million in 2000 to fund these safety activities. Surface Transportation Board fees.—The Administration proposes to create a fee mechanism to completely offset the expenses of the Surface Transportation Board (STB), the successor to the Interstate Commerce Commission (ICC). The fees would be collected from those who benefit from the continuation of the ICC functions transferred to the STB, i.e. railroads and shippers. DEPARTMENT OF THE TREASURY Customs, air/sea passenger fee.—The Administration proposes to increase an existing fee paid by travelers arriving by commercial aircraft and commercial vessels 4. USER FEES AND OTHER COLLECTIONS from a place outside of the United States, and to remove certain exemptions from this fee. Proceeds of the fee increase would partially offset Customs costs associated with air and sea passenger processing. Subsequent to the budget, authorization legislation will be transmitted to allow the Secretary to increase the fee paid by air and sea passengers and to remove existing exemptions from this fee. Customs, automation enhancement fee.—The Administration proposes to establish a fee for the use of Customs automated systems. The fee would be charged to users of any Customs automated system based on the amount of user data input. Proceeds of the fee would offset the costs of modernizing Customs automated commercial operations and an international trade data system, and would be available for obligation after FY 2000. Subsequent to the budget, authorization legislation will be transmitted to allow the Secretary to establish a fee for the use of Customs automated systems. ARMY CORPS OF ENGINEERS Regulatory program fees.—The Army Corps of Engineers has not changed the fee structure of its regulatory program since 1977. The Budget proposes to pursue reasonable changes that would reduce the fees paid from many applicants and increase recovery from commercial applicants. NATIONAL TRANSPORTATION SAFETY BOARD Commercial accident investigation fees.—To offset a portion of the NTSB’s growing cost of commercial accident investigations, a new aviation accident recovery and investigation fee is proposed. This fee, which would be paid by commercial air, motor, ocean, and rail carriers based on a proxy for risk, would collect an estimated $10 million in 2000. Collections from the following discretionary proposals be deposited in offsetting receipt accounts: DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT GSE Oversight Assessment Fee.—This proposal would assess Fannie Mae and Freddie Mac for the cost incurred by HUD offices (other than the Office of Federal Housing Enterprise Oversight) from regulating the activities of these government-sponsored enterprises. The fee would offset the actual costs incurred by HUD. ENVIRONMENTAL PROTECTION AGENCY Pesticide registration fees.—The budget proposes to reinstate pesticide registration fees that are statutorily suspended through 2001. These fees would be used to offset the cost of reviewing applications for pesticide registrations, amendments to registrations, and experimental use permits. Chemical pre-manufacturing notification (PMN) fees.—The Administration proposes to eliminate the statutory cap on PMN fees and to increase fees charged 99 to chemical producers to recover the cost of reviewing notifications of new chemicals prior to production. FEDERAL COMMUNICATIONS COMMISSION Analog spectrum lease fee.—The Administration proposes to set a lease fee on commercial television broadcasters’ use of spectrum for analog broadcasting. The lease fee would raise $200 million annually to fund programs in the Department of Justice, the Department of the Treasury, and the Department of the Interior to expand and upgrade public safety wireless communications. NUCLEAR REGULATORY COMMISSION Nuclear Regulatory Commission.—Under current law, the NRC must recover 100 percent of its costs from licensing, inspection, and annual fees charged to its applicants and licensees through 1999. Unless the law is extended, the fee covering requirement will revert to 33 percent of NRC’s cost of operations. The Administration proposes to extend fees at approximately 100 percent of the NRC’s cost of operations through 2004. SOCIAL SECURITY ADMINISTRATION Claimant representation fee.—The Budget proposes to impose a fee on persons who represent Supplemental Security Income claimants in administrative or judicial proceedings. This fee is designed to recover the cost of processing attorney fee agreements and determining the allowable charge under the fee petition process. This assessment would be imposed only if the claimant is awarded past due benefits and a fee for representation is approved by the Social Security Administration. Mandatory Receipts used to offset discretionary spending In some cases, the Administration is proposing to authorize collections that are not subject to action by the appropriators, while making those collections available to offset discretionary spending. The budget proposes authorizing legislation that will increase governmental or mandatory offsetting receipts. The savings from these proposals would be applied to discretionary spending. DEPARTMENT OF TRANSPORTATION Federal Aviation Administration (FAA), cost based user fees.—The Budget proposes to reduce the existing aviation excise taxes over time as more efficient, costbased user fees for air traffic services are phased in beginning in 2000. Under this proposal, the collections each year from the new cost-based user fees and the existing excise taxes combined would be equal to the total budget resources requested for the FAA in each succeeding year. In FY 2000, this proposal would result in the collection of $1.5 billion in additional aviation user charges. These charges will be deposited into a governmental receipt account and be made available for discretionary spending. 100 ANALYTICAL PERSPECTIVES ARMY CORPS OF ENGINEERS Harbor services fees.—The Administration proposes to replace collection of the ad valorem Harbor Maintenance Tax with a cost-based user fee, the Harbor Services User Fee. The user fee will finance construction and operation and maintenance of harbor activities performed by the Army Corps of Engineers, the costs of operating and maintaining the Saint Lawrence Seaway, and the costs of administering the fee. Through appropriations acts, the fee will raise an average of $980 million annually through FY 2004, which is less than would have been raised by the Harbor Maintenance Tax before the Supreme Court decision that the ad valorem tax on exports was unconstitutional. While the collections from the harbor services fee would be mandatory, collections would be available to offset discretionary spending. Mandatory Fee Proposals The following new and increased fees are classified as mandatory because they are proposed to be included in authorizing legislation and neither the collection or spending of the fee would be contingent upon appropriations action. Collections from the following proposal are to be deposited directly an appropriations accounts: FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) State bank examination fee.—The Administration proposes to require the FDIC and the Federal Reserve to assess fees for examinations of bank holding companies and state-chartered FDIC-insured banks. The costs of such examinations are currently funded from deposit insurance premiums and Federal Reserve earnings from monetary policy activities. The FDIC fee proceeds would be used to finance the examination operation. The Federal Reserve collections do not meet the technical definition of a user fee, but will be reflected in higher governmental receipts, and are discussed in the preceding chapter on governmental receipts. Collections from the following proposals are to be deposited in receipt accounts: DEPARTMENT OF HEALTH AND HUMAN SERVICES Medicare premiums for retirees under the age of 65 and displaced workers.—The Administration proposes to charge premiums based on an actuarially fair rate to people between the ages of 62 and 65 and displaced workers between 55 and 61 who elect to participate in the Medicare buy-in premium based program. This increase in premium collectons is partially offset by the reduction in premium collections due to the Medicare savings proposals. DEPARTMENT OF THE INTERIOR AND AGRICULTURE Increased recreation and entrance fee.—The Administration proposes to permanently extend the current pilot program which expires in 2001. The National Park Service, Fish and Wildlife Service, the Bureau of Land Management, and the Forest Service would be allowed to collect increased recreation and entrance fees and use the receipts without further appropriation for facility improvements and new services. The Forest Service would also be authorized to use collections from existing fees for similar improvements and services. Hardrock mining production fees.—The Administration proposes to charge mining companies a 5% fee on net smelter production from hard rock mining on Federal Lands. Filming and special use permits fee.—The Administration proposes to authorize the National Park Service and other land management agencies, including the Department of Agriculture’s Forest Service to increase fees for permits to use land and facilities for the making of motion pictures, television productions, still photos, sound tracks and other similar purposes. Collections would be available without further appropriations to cover related Government costs (as currently authorized) and provide a fair return to the Government. DEPARTMENT OF JUSTICE Immigration user fee.—The Administration proposes to increase the fee for inspection of passengers at air and seaports by the Immigration and Naturalization Service (INS) by $2.00 to $8.00. The immigration user fee recovers the costs of INS’ air and seaport inspection of passengers entering the United States and other activities authorized to be funded by the fee. The current fee of $6.00 per passenger is insufficient to maintain fee operations. In addition, the Administration is proposing to charge $3.00 for the inspection of commercial vessel passengers whose journey originated in Mexico, Canada, the United States or its territories and possession or any adjacent island. This inspection fee would be expanded to cover cruise ship passengers who, in the past, have been exempt from any inspection fee. DEPARTMENT OF THE TREASURY Extend Customs conveyance and passenger and merchandise processing fees.—Under existing legislation, the Customs Conveyance/Passenger Fee and the Merchandise Processing Fee will expire on September 30, 2003. The Administration proposes to extend both of these fees starting on October 1, 2003. The following proposal is classified as mandatory because it will be included in authorizing legislation, and their collection will not be contingent on appropriations language. Collections are recorded as governmental receipts, not as an offset to outlays. FEDERAL EMERGENCY MANAGEMENT AGENCY (FEMA) Mortgage transaction fees for flood hazard determination.—The Administration proposes to establish a $15 on all fee mortgage originations and refinancings to support a multi-year program to update and modernize FEMA’s inventory of flood plain maps (100,000 maps). Accurate and easy to use flood hazard maps are essential in determining if a property is located in a flood 101 4. USER FEES AND OTHER COLLECTIONS plain. The maps allow lenders to meet their statutory obligation of requiring the risk-prone homes they insure to carry flood insurance, and allow homeowners to assess their risk of flood damage. These maps are the basis for developing appropriate risk-based flood insurance premium charges, and improved maps will result in a more actuarially sound insurance program. OFFSETTING RECEIPTS Table 4–3 itemizes all offsetting collections deposited in receipt accounts. These include payments from one part of the Government to another, called intra-governmental transactions, and collections from the public. These receipts are offset (deducted) from outlays in the Federal budget. In total, offsetting receipts are estimated at $371.3 billion in 2000. 102 ANALYTICAL PERSPECTIVES Table 4–3. OFFSETTING RECEIPTS BY TYPE (In millions of dollars) Source 1998 Actual Estimate 1999 INTRAGOVERNMENTAL TRANSACTIONS On-budget receipts: Federal intrafund transactions: Distributed by agency: Interest from the Federal Financing Bank .................................................................... 4,141 2,736 Interest on Government capital in enterprises .............................................................. 1,758 1,443 Other ............................................................................................................................... 4,157 1,656 Proposed Legislation (non-PAYGO) .............................................................................. .................. .................. Total Federal intrafunds ................................................................................................. 2000 2001 2002 2003 2004 2,352 1,371 1,716 50 2,153 1,217 1,810 50 1,996 1,093 1,908 50 1,845 995 2,024 50 1,859 916 2,130 50 10,056 5,835 5,489 5,230 5,047 4,914 4,955 Trust intrafund transactions: Distributed by agency: Payments to railroad retirement .................................................................................... 3,819 Other ............................................................................................................................... .................. 3,712 1 3,630 1 3,528 1 3,638 1 3,640 1 3,636 1 Total trust intrafunds ...................................................................................................... 3,819 3,713 3,631 3,529 3,639 3,641 3,637 Total intrafund transactions ................................................................................................ 13,875 9,548 9,120 8,759 8,686 8,555 8,592 Interfund transactions: Distributed by agency: Federal fund payments to trust funds: Contributions to insurance programs: Military retirement fund .......................................................................................... 15,119 15,250 Supplementary medical insurance ........................................................................ 59,919 61,879 Proposed Legislation (non-PAYGO) ..................................................................... .................. .................. Hospital insurance ................................................................................................. 5,259 7,056 Railroad social security equivalent fund ............................................................... 58 94 Rail industry pension fund .................................................................................... 196 195 Civilian supplementary retirement contributions ................................................... 21,654 21,952 Unemployment insurance ...................................................................................... 508 473 Other contributions ................................................................................................ 383 416 Proposed Legislation (PAYGO) ............................................................................ .................. .................. Miscellaneous payments ....................................................................................... 568 581 Subtotal ...................................................................................................................... 103,664 107,896 15,900 16,500 17,200 17,800 18,600 68,690 75,479 82,157 89,322 95,276 –469 –648 –713 –775 –728 7,091 7,232 7,638 8,088 8,551 74 74 75 77 78 201 204 207 211 216 22,117 22,317 22,559 22,977 23,357 496 571 574 570 584 407 408 411 412 420 42 .................. .................. .................. .................. 429 436 437 413 405 114,978 122,573 130,545 139,095 146,759 Trust fund payments to Federal funds: Quinquennial adjustment for military service credits ................................................ .................. .................. .................. 1,121 .................. .................. .................. Other ........................................................................................................................... 1,123 1,062 1,052 1,076 1,103 1,131 1,160 Proposed Legislation (non-PAYGO) .......................................................................... .................. .................. 1,847 .................. .................. .................. .................. Subtotal ...................................................................................................................... 1,123 1,062 2,899 2,197 1,103 1,131 1,160 Total interfunds distributed by agency .......................................................................... 104,787 108,958 117,877 124,770 131,648 140,226 147,919 Undistributed by agency: Employer share, employee retirement (on-budget): Civil service retirement and disability insurance ....................................................... 8,682 8,817 CSRDI from Postal Service ....................................................................................... 6,109 6,071 Hospital insurance (contribution as employer) 1 ....................................................... 1,892 1,957 Postal employer contributions to FHI ........................................................................ 607 610 Military retirement fund .............................................................................................. 10,421 10,534 Legislative proposal, discretionary offset .................................................................. .................. .................. Other Federal employees retirement ........................................................................ 109 114 9,163 6,274 2,046 638 10,740 849 120 9,657 6,451 2,112 663 10,981 1,058 125 10,073 6,620 2,223 690 11,268 1,159 131 10,152 6,760 2,327 718 11,585 1,231 134 10,704 6,849 2,440 747 11,969 1,270 139 29,830 31,047 32,164 32,907 34,118 Interest received by on-budget trust funds ............................................................... 67,208 67,160 68,454 Proposed Legislation (non-PAYGO) .......................................................................... .................. 73 157 Legislative proposal, discretionary offset .................................................................. .................. .................. .................. 69,545 251 93 70,826 369 195 72,229 458 296 73,441 529 396 Total employer share, employee retirement (on-budget) ......................................... 27,820 28,103 Total interfund transactions undistributed by agency ................................................... 95,028 95,336 98,441 100,936 103,554 105,890 108,484 Total interfund transactions ................................................................................................ 199,815 204,294 216,318 225,706 235,202 246,116 256,403 103 4. USER FEES AND OTHER COLLECTIONS Table 4–3. OFFSETTING RECEIPTS BY TYPE—Continued (In millions of dollars) Estimate 1998 Actual 1999 2000 2001 2002 2003 2004 213,690 213,842 225,438 234,465 243,888 254,671 264,995 Off-budget receipts: Interfund transactions: Distributed by agency: Federal fund payments to trust funds: Old-age, survivors, and disability insurance ............................................................. 9,140 11,278 Undistributed by agency: Employer share, employee retirement (off-budget) .................................................. 7,052 7,355 Proposed Legislation (non-PAYGO) .......................................................................... .................. .................. Interest received by off-budget trust funds ............................................................... 46,629 51,869 10,340 10,818 11,383 12,033 12,785 7,969 –264 56,492 8,442 –271 62,107 9,102 –261 68,500 9,746 –260 75,448 10,442 –261 82,749 Source Total on-budget receipts ......................................................................................................... Total off-budget receipts: ........................................................................................................ 62,821 70,502 74,537 81,096 88,724 96,967 105,715 Total intragovernmental transactions ..................................................................................... 276,511 284,344 299,975 315,561 332,612 351,638 370,710 PROPRIETARY RECEIPTS FROM THE PUBLIC Distributed by agency: Interest: Interest on foreign loans and deferred foreign collections ............................................... Interest on deposits in tax and loan accounts .................................................................. Other interest (domestic—civil) 2 ....................................................................................... 799 1,228 6,036 768 1,050 7,142 638 1,115 8,149 684 1,105 9,193 641 1,105 10,231 706 1,105 11,264 695 1,105 12,234 Total interest ....................................................................................................................... 8,063 8,960 9,902 10,982 11,977 13,075 14,034 Royalties and rents ................................................................................................................. 1,248 1,324 1,368 Proposed Legislation (PAYGO) .......................................................................................... .................. .................. .................. 1,378 8 1,399 26 1,420 26 1,433 26 Sale of products: Sale of timber and other natural land products ................................................................ Sale of minerals and mineral products .............................................................................. Sale of power and other utilities ........................................................................................ Other ................................................................................................................................... 461 237 754 28 466 31 733 61 487 35 680 59 466 35 771 51 450 49 766 67 434 49 762 63 433 20 752 54 Total sale of products ......................................................................................................... 1,480 1,291 1,261 1,323 1,332 1,308 1,259 Fees and other charges for services and special benefits: Medicare premiums and other charges (trust funds) ........................................................ Proposed Legislation (PAYGO) .......................................................................................... Nuclear waste disposal revenues ...................................................................................... Veterans life insurance (trust funds) .................................................................................. Other 2 ................................................................................................................................ Proposed Legislation (non-PAYGO) .................................................................................. Proposed Legislation (PAYGO) .......................................................................................... Legislative proposal, discretionary offset ........................................................................... 20,747 .................. 600 217 2,279 .................. .................. .................. 21,299 .................. 642 207 1,909 .................. .................. .................. 22,969 –135 632 196 1,890 19 3 966 25,004 275 632 184 1,894 19 3 963 27,127 488 631 171 1,825 19 95 960 30,085 562 632 159 1,831 19 107 996 32,252 687 632 147 1,840 19 120 1,014 Total fees and other charges ............................................................................................. 23,843 24,057 26,540 28,974 31,316 34,391 36,711 Sale of Government property: Sale of land and other real property ................................................................................. 58 34 Proposed Legislation (PAYGO) .......................................................................................... .................. .................. Military assistance program sales (trust funds) ................................................................. 14,135 13,280 Other ................................................................................................................................... 146 541 85 2 12,690 346 70 4 12,140 177 571 11 12,050 177 71 11 9,720 143 70 11 8,610 83 13,123 12,391 12,809 9,945 8,774 Total sale of Government property .................................................................................... Realization upon loans and investments: Dollar repayments of loans, Agency for International Development ................................ Foreign military credit sales ............................................................................................... Negative subsidies and downward reestimates ................................................................ Repayment of loans to foreign nations ............................................................................. Other ................................................................................................................................... Total realization upon loans and investments ................................................................... 2 14,339 13,855 1 .................. .................. .................. .................. .................. .................. 534 371 .................. .................. .................. .................. .................. 4,300 8,296 933 691 2,491 2,577 2,814 134 285 251 252 134 72 80 153 76 78 82 131 111 108 5,122 9,028 Recoveries and refunds ....................................................................................................... 3,375 3,844 Proposed Legislation (PAYGO) .............................................................................................. .................. 142 Legislative proposal, discretionary offset ............................................................................... .................. .................. 1,262 1,025 2,756 2,760 3,002 3,977 4,244 5,416 4,350 4,443 168 300 349 276 194 788 .................. .................. .................. .................. 104 ANALYTICAL PERSPECTIVES Table 4–3. OFFSETTING RECEIPTS BY TYPE—Continued (In millions of dollars) Estimate 1998 Actual Source 1999 2000 2001 2002 2003 2004 Miscellaneous receipt accounts 2 ........................................................................................... 2,493 4,730 1,375 1,380 1,379 1,380 1,379 Total proprietary receipts from the public distributed by agency .......................................... 59,963 67,231 59,764 62,005 68,759 68,931 71,255 3 1,264 9 .................. .................. .................. .................. 1,500 846 3,022 2,277 5,158 .................. 327 324 248 194 194 2,452 2,474 2,558 2,479 2,414 323 .................. .................. .................. .................. 9,683 4,387 3,111 2,798 2,806 2,673 2,608 69,646 71,618 62,875 64,803 71,565 71,604 73,863 Undistributed by agency: Other interest: Interest received from Outer Continental Shelf escrow account .................. Rents and royalties on the Outer Continental Shelf: Rents and bonuses ............................................................................................................ Royalties .............................................................................................................................. Sale of major assets ............................................................................................................... Total proprietary receipts from the public undistributed by agency ...................................... Total proprietary receipts from the public 3 ......................................................................... OFFSETTING GOVERNMENTAL RECEIPTS Distributed by agency: Regulatory fees ....................................................................................................................... 2,861 3,164 3,360 3,395 3,360 3,437 Proposed Legislation (non-PAYGO) ....................................................................................... .................. .................. 20 20 20 20 Proposed Legislation (PAYGO) .............................................................................................. .................. .................. .................. .................. .................. .................. Other ........................................................................................................................................ 73 75 77 79 81 6 Undistributed by agency: Spectrum auction proceeds .................................................................................................... 2,642 1,447 4,819 2,801 7,065 1,770 Proposed Legislation (non-PAYGO) ....................................................................................... .................. .................. 200 200 200 200 1,975 20 1,522 6 775 200 Total offsetting governmental receipts ................................................................................... 5,576 4,686 8,476 6,495 10,726 5,433 4,498 Total offsetting receipts ........................................................................................................... 351,733 360,648 371,326 386,859 414,903 428,675 449,071 1 2 3 Includes provision for covered Federal civilian employees and military personnel. Includes both Federal funds and trust funds. Consists of: 1998 Actual On-budget: Federal funds .................................. Trust funds ...................................... Off-budget 33,181 36,445 20 Estimate 1999 2000 2001 2002 2003 2004 32,184 39,414 20 26,053 36,783 39 26,150 38,614 39 30,726 40,800 39 30,097 41,468 39 31,204 42,620 39 5. TAX EXPENDITURES Tax expenditures are revenue losses due to preferential provisions of the Federal tax laws, such as special exclusions, exemptions, deductions, credits, deferrals, or tax rates. They are alternatives to other policy instruments, such as spending or regulatory programs, as means of achieving Federal policy goals. Tax expenditures are created for a variety of reasons, including to encourage certain activities, to improve fairness, to ease compliance with and administration of the tax system, and to reduce certain tax-induced distortions. The Congressional Budget Act of 1974 (Public Law 93–344) requires that a list of tax expenditures be included in the budget. The largest tax expenditures tend to be associated with the individual income tax. For example, tax preferences are provided for pension contributions and earnings, employer contributions for medical insurance, mortgage interest payments on owner-occupied homes, capital gains, and payments of State and local individual income and property taxes. Tax expenditures under the corporate income tax tend to be related to the rate of cost recovery for various investments; as is discussed below, the extent to which these provisions are classified as tax expenditures varies according to the conceptual baseline used. Charitable contributions and credits for State taxes on bequests are the largest tax expenditures under the unified transfer (i.e., estate and gift) tax. Because of potential interactions among provisions, this chapter does not present a grand total revenue loss estimate for tax expenditures. Moreover, past tax changes entailing broad elimination of tax expenditures were generally accompanied by changes in tax rates or other basic provisions, so that the net effects on Federal revenues were considerably (if not totally) offset. Nevertheless, in aggregate, tax expenditures have revenue impacts of hundreds of billions of dollars, and are some of the most important ways in which the Federal Government affects economic decisions and social welfare. Tax expenditures relating to the individual and corporate income taxes are considered first in this chapter. They are estimated for fiscal years 1998–2004 using three methods of accounting: revenue loss, outlay equivalent, and present value. The present value approach provides estimates of the revenue losses for tax expenditures that involve deferrals of tax payments into the future or have similar long-term effects. Tax expenditures relating to the unified transfer tax are considered in a section at the end of the chapter. The section in this chapter on Performance Measures and the Economic Effects of Tax Expenditures presents information related to assessment of the effect of tax expenditures on the achievement of program performance goals. This section was prepared under the Government Performance and Results Act of 1993 and is included by reference in the government-wide performance plan required by this Act (see also Sections III, IV, and VI of the Budget volume). Tax expenditures are also discussed in Section VI of the Budget, which considers the Federal Government’s spending, regulatory, and tax policies across functional areas. TAX EXPENDITURES IN THE INCOME TAX Tax Expenditure Estimates The Treasury Department prepared all tax expenditure estimates presented here based upon tax law enacted as of December 31, 1998. The analysis includes new tax expenditures that were enacted in the Tax and Trade Relief Extension Act of 1998. Expired or repealed provisions are not listed if their revenue effects result only from taxpayer activity occurring before fiscal year 1998. Due to the time required to estimate the large number of tax expenditures, the estimates are based on mid-session economic assumptions; exceptions are the earned income tax credit and child credit provisions, which involve outlay components and hence are updated to reflect the economic assumptions used elsewhere in the budget. The total revenue loss estimates for tax expenditures for fiscal years 1998–2004 are displayed by the budget’s functional categories in table 5–1. Descriptions of the specific tax expenditure provisions follow the tables of estimates and discussion of general features of the tax expenditure concept. As in prior years, two baseline concepts—the normal tax baseline and the reference tax law baseline—are used to identify tax expenditures. For the most part, the two concepts coincide. However, items treated as tax expenditures under the normal tax baseline, but not the reference tax law baseline, are indicated by the designation ‘‘normal tax method’’ in the tables. The revenue losses for these items are zero using the reference tax rules. The alternative baseline concepts are discussed in detail following the estimates. Table 5–2 reports the respective portions of the total revenue losses that arise under the individual and corporate income taxes. Listing revenue loss estimates under the individual and corporate headings does not imply that these categories of filers benefit from the special tax provisions in proportion to the respective tax expenditure amounts shown. Rather, these break- 105 106 ANALYTICAL PERSPECTIVES downs show the specific tax accounts through which the various provisions are cleared. The ultimate beneficiaries of corporate tax expenditures could be stockholders, employees, customers, or others, depending on economic forces. Table 5–3 ranks the major tax expenditures by fiscal year 2000 revenue loss. This table merges several individual entries provided in table 5–1; for example, table 5–3 contains one merged entry for charitable contributions instead of the three separate entries found in table 5–1. Interpreting Tax Expenditure Estimates Tax expenditure revenue loss estimates do not necessarily equal the increase in Federal revenues (or the change in the budget balance) that would result from repealing the special provisions, for the following reasons: • Eliminating a tax expenditure may have incentive effects that alter economic behavior. These incentives can affect the resulting magnitudes of the formerly subsidized activity or of other tax preferences or Government programs. For example, if deductibility of mortgage interest were limited, some taxpayers would hold smaller mortgages, with a concomitantly smaller effect on the budget than if no such limits were in force. • Tax expenditures are interdependent even without incentive effects. Repeal of a tax expenditure provision can increase or decrease the revenue losses associated with other provisions. For example, even if behavior does not change, repeal of an itemized deduction could increase the revenue losses from other deductions because some taxpayers would be moved into higher tax brackets. Alternatively, repeal of an itemized deduction could lower the revenue loss from other deductions if taxpayers are led to claim the standard deduction instead of itemizing. Similarly, if two provisions were repealed simultaneously, the increase in tax liability could be greater or less than the sum of the two separate tax expenditures, since each is estimated assuming that the other remains in force. In addition, the estimates reported in Table 5–1 are the totals of individual and corporate income tax revenue losses reported in Table 5–2 and do not reflect any possible interactions between the individual and corporate income tax receipts. For this reason, the figures in Table 5–1 (as well as those in Table 5–5, which are also based on summing individual and corporate estimates) should be regarded as approximations. • Revenues raised by changes to tax expenditures are sensitive to timing effects and effective dates. Changes in some provisions would yield their full potential revenue gains relatively quickly, whereas changes to other provisions would only gradually yield their full revenue potential, as certain deductions or exemptions would likely be grandfathered. • The annual value of tax expenditures for tax deferrals is reported on a cash basis in all tables except Table 5–4. Cash-based estimates reflect the difference between taxes deferred in the current year and incoming revenues that are received due to deferrals of taxes from prior years. While such estimates are useful as a measure of cash flows into the Government, they do not accurately reflect the true economic cost of these provisions. For example, for a provision where activity levels have changed, so that incoming tax receipts from past deferrals are greater than deferred receipts from new activity, the cash-basis tax expenditure estimate can be negative, despite the fact that in present-value terms current deferrals do have a real cost to the Government. Alternatively, in the case of a newly enacted deferral provision, a cash-based estimate can overstate the real cost to the Government because the newly deferred taxes will ultimately be received. Present-value estimates, which are a useful supplement to the cash-basis estimates for provisions involving deferrals, are discussed below. • Repeal of some provisions could affect overall levels of income and rates of economic growth. In principle, repeal of major tax provisions may have some impact on the budget economic assumptions. In general, however, most changes in particular provisions are unlikely to have significant macroeconomic effects. Present-Value Estimates Discounted present-value estimates of revenue losses are presented in Table 5–4 for certain provisions that involve tax deferrals or other long-term revenue effects. These estimates complement the cash-based tax expenditure estimates presented in the other tables. The present-value estimates represent the revenue losses, net of future tax payments, that follow from activities undertaken during calendar year 1999 which cause the deferrals or other long-term revenue effects. For instance, a pension contribution in 1999 would cause a deferral of tax payments on wages in 1999 and on pension earnings on this contribution (e.g., interest) in later years. In some future year, however, the 1999 pension contribution and accrued earnings will be paid out and taxes will be due; these receipts are included in the present-value estimate. In general, this conceptual approach is similar to the one used for reporting the budgetary effects of credit programs, where direct loans and guarantees in a given year affect future cash flows. 107 5. TAX EXPENDITURES Table 5–1. TOTAL REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX (In millions of dollars) Total revenue loss from corporate and individual Income taxes 1998 1999 2000 2001 2002 2003 2004 2000–2004 1 National Defense: Exclusion of benefits and allowances to armed forces personnel .......................................................... 2,095 2,120 2,140 2,160 2,180 2,200 2,220 10,900 2 3 4 5 6 International affairs: Exclusion of income earned abroad by U.S. citizens ............................................................................. Exclusion of income of foreign sales corporations .................................................................................. Inventory property sales source rules exception ..................................................................................... Deferral of income from controlled foreign corporations (normal tax method) ....................................... Deferred taxes for financial firms on certain income earned overseas .................................................. 1,990 2,150 1,000 5,500 400 2,235 2,250 1,050 5,800 1,075 2,500 2,400 1,100 6,200 65 2,800 2,550 1,150 6,600 0 3,125 2,700 1,250 7,000 0 3,460 2,900 1,350 7,450 0 3,830 3,100 1,450 7,900 0 15,715 13,650 6,300 35,150 65 7 8 General science, space, and technology: Expensing of research and experimentation expenditures (normal tax method) ................................... Credit for increasing research activities ................................................................................................... 260 2,125 330 1,655 510 980 610 425 675 180 735 60 765 0 3,295 1,645 9 10 11 12 13 14 15 16 17 18 19 Energy: Expensing of exploration and development costs, fuels ......................................................................... Excess of percentage over cost depletion, fuels ..................................................................................... Alternative fuel production credit .............................................................................................................. Exception from passive loss limitation for working interests in oil and gas properties ......................... Capital gains treatment of royalties on coal ............................................................................................ Exclusion of interest on energy facility bonds ......................................................................................... Enhanced oil recovery credit .................................................................................................................... New technology credit ............................................................................................................................... Alcohol fuel credits 1 ................................................................................................................................. Tax credit and deduction for clean-fuel burning vehicles ....................................................................... Exclusion from income of conservation subsidies provided by public utilities ....................................... –110 250 860 30 60 110 140 25 15 75 80 –70 260 810 35 65 110 160 30 15 80 80 –10 265 760 35 65 110 180 35 15 90 80 –15 270 720 35 70 115 210 40 15 95 75 0 275 675 40 70 115 240 40 15 90 75 30 280 435 40 75 115 275 35 15 75 75 40 290 125 40 80 115 320 35 15 60 80 45 1,380 2,715 190 360 570 1,225 185 75 410 385 20 21 22 23 24 25 26 Natural resources and environment: Expensing of exploration and development costs, nonfuel minerals ...................................................... Excess of percentage over cost depletion, nonfuel minerals ................................................................. Exclusion of interest on bonds for water, sewage, and hazardous waste facilities .............................. Capital gains treatment of certain timber income .................................................................................... Expensing of multiperiod timber growing costs ....................................................................................... Investment credit and seven-year amortization for reforestation expenditures ...................................... Tax incentives for preservation of historic structures .............................................................................. 25 225 440 60 485 10 215 25 240 440 65 500 10 235 25 245 445 65 510 10 255 25 255 455 70 530 10 275 25 270 455 70 550 15 285 30 280 460 75 570 15 305 30 295 465 80 590 15 315 135 1,345 2,280 360 2,750 65 1,435 27 28 29 30 31 32 Agriculture: Expensing of certain capital outlays ......................................................................................................... Expensing of certain multiperiod production costs .................................................................................. Treatment of loans forgiven for solvent farmers ...................................................................................... Capital gains treatment of certain income ............................................................................................... Income averaging for farmers ................................................................................................................... Deferral of gain on sale of farm refiners ................................................................................................. 65 80 10 605 10 10 70 85 10 630 75 10 70 85 10 655 75 10 75 90 10 685 80 10 75 95 10 715 80 10 80 100 10 750 80 15 85 105 10 785 85 15 385 475 50 3,590 400 60 785 70 13,465 5 210 100 840 30 14,200 5 225 100 905 10 14,990 5 240 100 970 5 15,810 5 260 105 1,040 5 16,680 5 275 105 1,120 5 17,595 5 310 110 1,200 0 18,840 5 325 100 5,235 25 83,915 25 1,410 520 860 150 51,700 17,770 975 17,475 4,735 3,120 2,405 875 150 52,990 18,595 995 18,000 4,455 3,225 2,740 880 150 55,100 19,495 1,015 18,540 4,215 3,335 3,095 885 150 57,590 20,535 1,035 19,095 4,000 3,485 4,170 900 155 60,415 21,625 1,055 19,670 3,785 3,540 4,590 905 155 63,425 22,635 1,075 20,260 3,575 3,620 4,495 915 155 66,615 23,645 1,095 20,870 3,375 3,615 4,570 4,485 765 303,145 107,935 5,275 98,435 18,950 17,595 20,920 50 155 38,275 0 24,570 170 35 6,270 30 160 39,415 5 25,800 175 35 4,895 20 160 40,585 5 27,090 185 35 3,430 15 160 41,795 5 28,240 195 40 2,385 20 165 43,035 5 29,370 205 40 2,365 20 165 44,310 5 30,545 210 40 1,875 25 165 45,625 5 31,765 220 40 585 100 815 215,350 25 147,010 1,015 195 10,640 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 Commerce and housing: Financial institutions and insurance: Exemption of credit union income ....................................................................................................... Excess bad debt reserves of financial institutions .............................................................................. Exclusion of interest on life insurance savings ................................................................................... Special alternative tax on small property and casualty insurance companies .................................. Tax exemption of certain insurance companies owned by tax-exempt organizations ...................... Small life insurance company deduction ............................................................................................. Housing: Exclusion of interest on owner-occupied mortgage subsidy bonds .................................................... Exclusion of interest on rental housing bonds .................................................................................... Deductibility of mortgage interest on owner-occupied homes ............................................................ Deductibility of State and local property tax on owner-occupied homes ........................................... Deferral of income from post-1987 installment sales .......................................................................... Capital gains exclusion on home sales ............................................................................................... Exception from passive loss rules for $25,000 of rental loss ............................................................ Credit for low-income housing investments ......................................................................................... Accelerated depreciation on rental housing (normal tax method) ...................................................... Commerce: Cancellation of indebtedness ............................................................................................................... Exceptions from imputed interest rules ............................................................................................... Capital gains (except agriculture, timber, iron ore, and coal) (normal tax method) .......................... Capital gains exclusion of small corporation stock ............................................................................. Step-up basis of capital gains at death ............................................................................................... Carryover basis of capital gains on gifts ............................................................................................. Ordinary income treatment of loss from small business corporation stock sale ............................... Accelerated depreciation of buildings other than rental housing (normal tax method) ..................... 108 ANALYTICAL PERSPECTIVES Table 5–1. TOTAL REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued (In millions of dollars) Total revenue loss from corporate and individual Income taxes 1998 1999 2000 2001 2002 2003 2004 2000–2004 56 57 58 59 60 Accelerated depreciation of machinery and equipment (normal tax method) .................................... Expensing of certain small investments (normal tax method) ............................................................ Amortization of start-up costs (normal tax method) ............................................................................ Graduated corporation income tax rate (normal tax method) ............................................................. Exclusion of interest on small issue bonds ......................................................................................... 28,885 1,185 205 5,400 295 32,505 1,235 215 5,360 300 35,465 1,275 220 5,360 305 36,830 1,175 225 5,620 305 36,985 1,730 225 6,120 305 36,510 1,605 230 6,680 310 35,855 995 240 7,120 310 181,645 6,780 1,140 30,900 1,535 61 62 63 Transportation: Deferral of tax on shipping companies .................................................................................................... Exclusion of reimbursed employee parking expenses ............................................................................ Exclusion for employer-provided transit passes ...................................................................................... 15 1,560 70 15 1,595 80 15 1,630 95 15 1,690 105 15 1,750 130 15 1,815 155 15 1,885 170 75 8,770 655 64 65 66 67 68 Community and regional development: Investment credit for rehabilitation of structures (other than historic) .................................................... Exclusion of interest for airport, dock, and similar bonds ....................................................................... Exemption of certain mutuals’ and cooperatives’ income ....................................................................... Empowerment zones and enterprise communities .................................................................................. Expensing of environmental remediation costs ....................................................................................... 30 695 45 290 90 30 705 50 380 110 30 710 50 430 145 30 715 50 435 60 30 725 50 415 –10 30 730 50 305 –25 30 740 55 290 –35 150 3,620 255 1,875 135 910 200 110 20 70 85 235 560 0 10 875 3,525 2,880 215 955 4,015 2,510 100 245 125 235 570 10 10 915 18,740 2,940 215 995 4,855 2,655 230 265 180 240 570 20 15 965 18,725 3,065 210 1,040 5,325 2,970 380 315 235 245 575 30 15 1,015 18,430 3,195 15 1,085 5,730 3,015 540 360 285 245 580 35 15 1,055 18,160 3,350 0 1,135 5,765 3,355 710 385 330 250 590 35 15 1,105 17,745 3,505 0 1,185 5,950 4,565 885 425 365 250 595 35 20 1,155 17,155 3,680 0 5,440 27,625 16,560 2,745 1,750 1,395 1,230 2,910 155 80 5,295 90,215 16,795 225 83 84 85 86 87 88 89 90 91 92 93 Education, training, employment, and social services: Education: Exclusion of scholarship and fellowship income (normal tax method) ............................................... HOPE tax credit .................................................................................................................................... Lifetime Learning tax credit .................................................................................................................. Education Individual Retirement Accounts ........................................................................................... Deductibility of student-loan interest .................................................................................................... Deferral for State prepaid tuition plans ................................................................................................ Exclusion of interest on student-loan bonds ....................................................................................... Exclusion of interest on bonds for private nonprofit educational facilities ......................................... Credit for holders of zone academy bonds ......................................................................................... Exclusion of interest on savings bonds redeemed to finance educational expenses ....................... Parental personal exemption for students age 19 or over ................................................................. Child credit 2 .......................................................................................................................................... Deductibility of charitable contributions (education) ............................................................................ Exclusion of employer-provided educational assistance ..................................................................... Training, employment, and social services: Work opportunity tax credit .................................................................................................................. Welfare-to-work tax credit ..................................................................................................................... Exclusion of employer-provided child care .......................................................................................... Adoption assistance .............................................................................................................................. Exclusion of employee meals and lodging (other than military) ......................................................... Credit for child and dependent care expenses ................................................................................... Credit for disabled access expenditures .............................................................................................. Expensing of costs of removing certain architectural barriers to the handicapped ........................... Deductibility of charitable contributions, other than education and health ......................................... Exclusion of certain foster care payments .......................................................................................... Exclusion of parsonage allowances ..................................................................................................... 170 15 1,325 125 620 2,485 45 0 18,580 35 315 335 35 1,385 295 650 2,455 50 5 19,150 35 340 330 35 1,445 345 680 2,425 50 5 20,055 40 360 160 20 1,510 390 710 2,395 50 5 21,005 40 385 40 10 1,575 385 740 2,365 55 5 22,050 45 410 5 5 1,645 235 775 2,340 60 5 23,150 45 440 0 0 1,715 170 810 2,310 60 5 24,335 50 470 535 70 7,890 1,525 3,715 11,835 275 25 110,595 220 2,065 94 95 96 97 98 99 100 101 02 Health: Exclusion of employer contributions for medical insurance premiums and medical care ..................... Self-employed medical insurance premiums ............................................................................................ Workers’ compensation insurance premiums ........................................................................................... Medical Savings Accounts ........................................................................................................................ Deductibility of medical expenses ............................................................................................................ Exclusion of interest on hospital construction bonds .............................................................................. Deductibility of charitable contributions (health) ...................................................................................... Tax credit for orphan drug research ........................................................................................................ Special Blue Cross/Blue Shield deduction ............................................................................................... 67,920 765 4,260 15 3,615 1,160 2,560 40 210 72,535 980 4,420 20 3,775 1,170 2,630 50 230 77,670 1,310 4,585 25 3,985 1,185 2,730 55 250 83,095 1,405 4,755 25 4,215 1,190 2,860 60 280 88,830 1,550 4,935 20 4,475 1,205 3,000 70 325 94,960 2,055 5,120 20 4,750 1,220 3,145 80 290 101,520 2,905 5,315 15 5,035 1,230 3,300 90 250 446,075 9,225 24,710 105 22,460 6,030 15,035 355 1,395 420 5,140 440 85 120 420 5,330 345 80 125 425 5,475 360 75 130 425 5,940 375 70 135 430 6,205 390 70 140 435 6,480 405 65 140 440 6,755 420 60 145 2,155 30,855 1,950 340 690 82,215 10,565 3,930 82,195 10,770 4,025 84,350 11,170 4,255 86,670 11,440 4,495 89,155 11,550 4,750 91,810 11,485 5,010 94,455 11,270 5,285 446,440 56,915 23,795 2,030 2,075 2,120 2,170 2,220 2,270 2,335 11,115 69 70 71 72 73 74 75 76 77 78 79 80 81 82 103 104 105 106 107 108 109 110 111 Income security: Exclusion of railroad retirement system benefits ..................................................................................... Exclusion of workers’ compensation benefits .......................................................................................... Exclusion of public assistance benefits (normal tax method) ................................................................. Exclusion of special benefits for disabled coal miners ........................................................................... Exclusion of military disability pensions ................................................................................................... Net exclusion of pension contributions and earnings: Employer plans ..................................................................................................................................... Individual Retirement Accounts ............................................................................................................ Keogh plans .......................................................................................................................................... Exclusion of other employee benefits: Premiums on group term life insurance .............................................................................................. 109 5. TAX EXPENDITURES Table 5–1. TOTAL REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued (In millions of dollars) Total revenue loss from corporate and individual Income taxes 1998 1999 2000 2001 2002 2003 2004 2000–2004 112 113 114 115 116 117 118 119 Premiums on accident and disability insurance .................................................................................. Income of trusts to finance supplementary unemployment benefits ....................................................... Special ESOP rules .................................................................................................................................. Additional deduction for the blind ............................................................................................................. Additional deduction for the elderly .......................................................................................................... Tax credit for the elderly and disabled .................................................................................................... Deductibility of casualty losses ................................................................................................................. Earned income tax credit 3 ....................................................................................................................... 175 5 920 30 1,690 40 225 6,351 185 5 950 30 1,720 40 235 5,118 195 5 980 30 1,740 40 245 4,971 205 5 1,020 30 1,795 40 255 5,142 215 5 1,060 35 1,880 40 270 5,275 225 5 1,100 35 1,945 40 280 5,471 235 5 1,140 35 2,020 40 290 5,672 1,075 25 5,300 165 9,380 200 1,340 26,531 120 121 122 Social Security: Exclusion of social security benefits: Social Security benefits for retired workers ......................................................................................... Social Security benefits for disabled .................................................................................................... Social Security benefits for dependents and survivors ....................................................................... 16,780 2,265 3,725 17,210 2,420 3,785 18,125 2,615 3,910 19,045 2,820 4,065 20,100 3,060 4,235 21,260 3,325 4,405 22,460 3,625 4,575 100,990 15,445 21,190 123 124 125 126 Veterans benefits and services: Exclusion of veterans death benefits and disability compensation ......................................................... Exclusion of veterans pensions ................................................................................................................ Exclusion of GI bill benefits ...................................................................................................................... Exclusion of interest on veterans housing bonds .................................................................................... 2,820 65 65 40 2,940 65 75 40 3,070 70 85 40 3,210 75 90 40 3,350 80 90 40 3,495 85 95 40 3,650 85 100 40 16,775 395 460 200 127 128 129 General purpose fiscal assistance: Exclusion of interest on public purpose bonds ........................................................................................ Deductibility of nonbusiness State and local taxes other than on owner-occupied homes .................. Tax credit for corporations receiving income from doing business in U.S. possessions ...................... 20,050 32,795 3,960 20,250 34,925 4,000 20,450 37,000 4,120 20,660 39,235 4,245 20,865 41,715 4,285 21,075 44,490 4,150 21,285 47,400 4,215 104,335 209,840 21,015 130 Interest: Deferral of interest on U.S. savings bonds .............................................................................................. 965 1,015 1,065 1,115 1,175 1,235 1,295 5,885 17,770 32,795 18,595 34,925 19,495 37,000 20,535 39,235 21,625 41,715 22,635 44,490 23,645 47,400 107,935 209,840 20,050 110 440 295 860 150 695 235 560 1,160 40 20,250 110 440 300 875 150 705 235 570 1,170 40 20,450 110 445 305 880 150 710 240 570 1,185 40 20,660 115 455 305 885 150 715 245 575 1,190 40 20,865 115 455 305 900 155 725 245 580 1,205 40 21,075 115 460 310 905 155 730 250 590 1,220 40 21,285 115 465 310 915 155 740 250 595 1,230 40 104,335 570 2,280 1,535 4,485 765 3,620 1,230 2,910 6,030 200 Addendum—Aid to State and local governments: Deductibility of: Property taxes on owner-occupied homes .......................................................................................... Nonbusiness State and local taxes other than on owner-occupied homes ....................................... Exclusion of interest on: Public purpose State and local debt .................................................................................................... IDBs for certain energy facilities .......................................................................................................... IDBs for pollution control and sewage and waste disposal facilities ................................................. Small-issue IDBs ................................................................................................................................... Owner-occupied mortgage revenue bonds .......................................................................................... State and local debt for rental housing ............................................................................................... IDBs for airports, docks, and sports and convention facilities ........................................................... State and local student loan bonds ..................................................................................................... State and local debt for private nonprofit educational facilities .......................................................... State and local debt for private nonprofit health facilities .................................................................. State and local debt for veterans housing .......................................................................................... 1 In addition, the partial exemption from the excise tax for alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1998 $680; 1999 $725; 2000 $755; 2001 $765; 2002 $790; 2003 $805; and 2004 $830. 2 The figures in the table indicate the effect of the child tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $0; 1999 $415; 2000 $528; 2001 $496; 2002 $483; 2003 $453; and 2004 $425. 3 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $23,239; 1999 $26,273; 2000 $26,882; 2001 $27,667; 2002 $28,632; 2003 $29,566; and 2004 $30,578. Note: Provisions with estimates denoted ‘‘normal tax method’’ have no revenue loss under the reference tax law method. All estimates have been rounded to the nearest $5 million. Provisions with estimates that rounded to zero in each year are not included in the table. 110 ANALYTICAL PERSPECTIVES Table 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES (In millions of dollars) Revenue Loss Corporations 1998 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 1999 2000 2001 Individuals 2002 2003 2000– 2004 2004 National Defense Exclusion of benefits and allowances to armed forces personnel ............................. ............ ............ ............ ............ ............ ............ ............ .............. 1999 2000 2001 2002 2003 2,095 2,120 2,140 2,160 2,180 2,200 2,220 10,900 3,125 3,460 3,830 15,715 International affairs: Exclusion of income earned abroad by U.S. citizens ........................................................ ............ ............ ............ ............ ............ ............ ............ .............. 1,990 2,235 2,500 2,800 Exclusion of income of foreign sales corporations ..................................................... 2,150 2,250 2,400 2,550 2,700 2,900 3,100 13,650 ............ ............ ............ ............ Inventory property sales source rules exception .............................................................. 1,000 1,050 1,100 1,150 1,250 1,350 1,450 6,300 ............ ............ ............ ............ Deferral of income from controlled foreign corporations (normal tax method) ............. 5,500 5,800 6,200 6,600 7,000 7,450 7,900 35,150 ............ ............ ............ ............ Deferred taxes for financial firms on certain income earned overseas ........................... 400 1,075 65 0 0 0 0 65 ............ ............ ............ ............ General science, space, and technology: Expensing of research and experimentation expenditures (normal tax method) ............ Credit for increasing research activities ........ 255 2,095 325 1,625 500 965 600 425 665 180 720 60 750 0 3,235 1,630 2000– 2004 1998 5 30 5 30 10 15 10 0 2004 ............ ............ .............. .............. ............ ............ .............. .............. ............ ............ .............. .............. ............ ............ .............. .............. 10 0 15 0 15 0 60 15 Energy: Expensing of exploration and development costs, fuels ................................................. –90 –55 –10 –15 0 25 30 30 –20 –15 0 0 0 5 10 15 Excess of percentage over cost depletion, fuels ............................................................ 200 205 210 215 220 225 235 1,105 50 55 55 55 55 55 55 275 Alternative fuel production credit ................... 815 765 720 680 640 420 120 2,580 45 45 40 40 35 15 5 135 Exception from passive loss limitation for working interests in oil and gas properties ............ ............ ............ ............ ............ ............ ............ .............. 30 35 35 35 40 40 40 190 Capital gains treatment of royalties on coal ............ ............ ............ ............ ............ ............ ............ .............. 60 65 65 70 70 75 80 360 Exclusion of interest on energy facility bonds 30 30 30 30 30 30 30 150 80 80 80 85 85 85 85 420 Enhanced oil recovery credit ......................... 130 150 170 195 225 260 300 1,150 10 10 10 15 15 15 20 75 New technology credit .................................... 25 30 35 40 40 35 35 185 ............ ............ ............ ............ ............ ............ .............. .............. 1 Alcohol fuel credits ....................................... 10 10 10 10 10 10 10 50 5 5 5 5 5 5 5 25 Tax credit and deduction for clean-fuel burning vehicles ................................................ 60 65 75 80 75 60 50 340 15 15 15 15 15 15 10 70 Exclusion from income of conservation subsidies provided by public utilities ............... ............ ............ ............ ............ ............ ............ ............ .............. 80 80 80 75 75 75 80 385 Natural resources and environment: Expensing of exploration and development costs, nonfuel minerals .............................. 20 20 20 20 20 25 25 110 Excess of percentage over cost depletion, nonfuel minerals ......................................... 180 190 195 205 215 225 235 1,075 Exclusion of interest on bonds for water, sewage, and hazardous waste facilities ... 115 115 115 120 120 120 120 595 Capital gains treatment of certain timber income ........................................................... ............ ............ ............ ............ ............ ............ ............ .............. Expensing of multiperiod timber growing costs ........................................................... 300 310 315 330 340 355 365 1,705 Investment credit and seven-year amortization for reforestation expenditures ............. ............ ............ ............ ............ ............ ............ ............ .............. Tax incentives for preservation of historic structures .................................................... 175 195 210 225 235 250 260 1,180 Agriculture: Expensing of certain capital outlays .............. 10 10 10 10 10 10 10 50 Expensing of certain multiperiod production costs ........................................................... 10 10 10 10 10 10 10 50 Treatment of loans forgiven for solvent farmers ............................................................... ............ ............ ............ ............ ............ ............ ............ .............. Capital gains treatment of certain income .... ............ ............ ............ ............ ............ ............ ............ .............. Income averaging for farmers ........................ ............ ............ ............ ............ ............ ............ ............ .............. Deferral of gain on sale of farm refiners ...... 10 10 10 10 10 15 15 60 Commerce and housing: Financial institutions and insurance: Exemption of credit union income ............. Excess bad debt reserves of financial institutions ................................................. Exclusion of interest on life insurance savings ................................................... Special alternative tax on small property and casualty insurance companies ....... Tax exemption of certain insurance companies owned by tax-exempt organizations ........................................................ 5 5 5 5 5 5 5 25 45 50 50 50 55 55 60 270 325 325 330 335 335 340 345 1,685 60 65 65 70 70 75 80 360 185 190 195 200 210 215 225 1,045 10 10 10 10 15 15 15 65 40 40 45 50 50 55 55 255 55 60 60 65 65 70 75 335 70 75 75 80 85 90 95 425 10 605 10 10 630 75 10 655 75 10 685 80 10 715 80 10 750 80 10 785 85 50 3,590 400 785 840 905 970 1,040 1,120 1,200 5,235 ............ ............ ............ ............ ............ ............ .............. .............. 70 30 10 5 5 5 0 25 ............ ............ ............ ............ ............ ............ .............. .............. 200 210 225 235 250 260 275 5 5 5 5 5 5 5 25 ............ ............ ............ ............ ............ ............ .............. .............. 210 225 240 260 275 310 325 1,410 ............ ............ ............ ............ ............ ............ .............. .............. 1,245 13,265 13,990 14,765 15,575 16,430 17,335 18,565 82,670 111 5. TAX EXPENDITURES Table 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES—Continued (In millions of dollars) Revenue Loss Corporations 1998 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 Small life insurance company deduction .. Housing: Exclusion of interest on owner-occupied mortgage subsidy bonds ....................... Exclusion of interest on rental housing bonds ..................................................... Deductibility of mortgage interest on owner-occupied homes .......................... Deductibility of State and local property tax on owner-occupied homes .............. Deferral of income from post-1987 installment sales ............................................. Capital gains exclusion on home sales .... Exception from passive loss rules for $25,000 of rental loss ........................... Credit for low-income housing investments Accelerated depreciation on rental housing (normal tax method) ........................ Commerce: Cancellation of indebtedness ..................... Exceptions from imputed interest rules ..... Capital gains (except agriculture, timber, iron ore, and coal) (normal tax method) Capital gains exclusion of small corporation stock ................................................ Step-up basis of capital gains at death .... Carryover basis of capital gains on gifts .. Ordinary income treatment of loss from small business corporation stock sale .. Accelerated depreciation of buildings other than rental housing (normal tax method) .................................................. Accelerated depreciation of machinery and equipment (normal tax method) .... Expensing of certain small investments (normal tax method) .............................. Amortization of start-up costs (normal tax method) .................................................. Graduated corporation income tax rate (normal tax method) .............................. Exclusion of interest on small issue bonds 1999 2000 2001 2002 Individuals 2003 2004 2000– 2004 1998 1999 2000 2001 2002 2003 2004 2000– 2004 100 100 100 105 105 110 100 520 ............ ............ ............ ............ ............ ............ .............. .............. 225 230 230 230 235 235 240 1,170 635 645 650 655 665 670 675 3,315 40 40 40 40 40 40 40 200 110 110 110 110 115 115 115 565 ............ ............ ............ ............ ............ ............ ............ .............. 51,700 52,990 55,100 57,590 60,415 63,425 66,615 303,145 ............ ............ ............ ............ ............ ............ ............ .............. 17,770 18,595 19,495 20,535 21,625 22,635 23,645 107,935 255 260 265 270 275 280 285 1,375 720 735 750 765 780 795 ............ ............ ............ ............ ............ ............ ............ .............. 17,475 18,000 18,540 19,095 19,670 20,260 810 20,870 3,900 98,435 ............ ............ ............ ............ ............ ............ ............ .............. 2,340 2,420 2,500 2,615 2,655 2,715 2,710 13,195 4,735 780 4,455 805 4,215 835 4,000 870 3,785 885 3,575 905 3,375 905 18,950 4,400 14,350 755 860 970 1,325 1,455 1,405 1,415 6,570 ............ ............ ............ ............ ............ ............ ............ .............. ............ ............ ............ ............ ............ ............ ............ .............. 50 155 30 160 20 160 15 160 20 165 20 165 25 165 100 815 1,650 1,880 2,125 2,845 3,135 3,090 3,155 ............ ............ ............ ............ ............ ............ ............ .............. 38,275 39,415 40,585 41,795 43,035 44,310 45,625 215,350 ............ ............ ............ ............ ............ ............ ............ .............. 0 5 5 5 5 5 ............ ............ ............ ............ ............ ............ ............ .............. 24,570 25,800 27,090 28,240 29,370 30,545 ............ ............ ............ ............ ............ ............ ............ .............. 170 175 185 195 205 210 5 25 31,765 147,010 220 1,015 ............ ............ ............ ............ ............ ............ ............ .............. 35 35 35 40 40 40 40 195 7,865 1,635 1,275 880 600 645 515 135 2,775 22,025 24,645 26,800 27,835 28,050 27,790 27,380 137,855 6,860 7,860 8,665 8,995 8,935 8,720 8,475 43,790 4,635 3,620 2,550 1,785 1,720 1,360 450 805 840 875 820 1,200 1,125 730 4,750 380 395 400 355 530 480 265 2,030 120 125 130 130 130 135 140 665 85 90 90 95 95 95 100 475 5,400 75 5,360 80 5,360 80 5,620 80 6,120 80 6,680 80 7,120 80 30,900 ............ ............ ............ ............ ............ ............ .............. .............. 400 220 220 225 225 225 230 230 1,135 Transportation: Deferral of tax on shipping companies ......... 15 15 15 15 15 15 15 75 ............ ............ ............ ............ ............ ............ .............. .............. Exclusion of reimbursed employee parking expenses .................................................... ............ ............ ............ ............ ............ ............ ............ .............. 1,560 1,595 1,630 1,690 1,750 1,815 1,885 8,770 Exclusion for employer-provided transit passes ........................................................ ............ ............ ............ ............ ............ ............ ............ .............. 70 80 95 105 130 155 170 655 Community and regional development: Investment credit for rehabilitation of structures (other than historic) .......................... Exclusion of interest for airport, dock, and similar bonds .............................................. Exemption of certain mutuals’ and cooperatives’ income .............................................. Empowerment zones and enterprise communities ........................................................... Expensing of environmental remediation costs ........................................................... Education, training, employment, and social services: Education: Exclusion of scholarship and fellowship income (normal tax method) .................... HOPE tax credit ......................................... Lifetime Learning tax credit ....................... Education Individual Retirement Accounts Deductibility of student-loan interest ......... Deferral for State prepaid tuition plans ..... Exclusion of interest on student-loan bonds ..................................................... Exclusion of interest on bonds for private nonprofit educational facilities ............... 15 15 15 15 15 15 15 75 15 15 15 15 15 15 15 75 180 185 185 185 190 190 195 945 515 520 525 530 535 540 545 2,675 45 50 50 50 50 50 55 135 185 205 190 170 130 115 810 155 195 225 245 245 175 175 1,065 75 90 120 50 –10 –20 –30 110 15 20 25 10 0 –5 –5 25 ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ .............. .............. .............. .............. .............. .............. 910 200 110 20 70 85 955 4,015 2,510 100 245 125 995 4,855 2,655 230 265 180 1,040 5,325 2,970 380 315 235 1,085 5,730 3,015 540 360 285 1,135 5,765 3,355 710 385 330 1,185 5,950 4,565 885 425 365 5,440 27,625 16,560 2,745 1,750 1,395 60 60 65 65 65 65 65 325 175 175 175 180 180 185 185 905 145 150 150 150 150 155 155 760 415 420 420 425 430 435 440 2,150 255 ............ ............ ............ ............ ............ ............ .............. .............. 112 ANALYTICAL PERSPECTIVES Table 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES—Continued (In millions of dollars) Revenue Loss Corporations 1998 77 78 79 80 81 82 83 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 Credit for holders of zone academy bonds Exclusion of interest on savings bonds redeemed to finance educational expenses .................................................... Parental personal exemption for students age 19 or over ....................................... Child credit 2 ............................................... Deductibility of charitable contributions (education) ............................................. Exclusion of employer-provided educational assistance ................................ Training, employment, and social services: Work opportunity tax credit ....................... Welfare-to-work tax credit .......................... Exclusion of employer-provided child care Adoption assistance ................................... Exclusion of employee meals and lodging (other than military) ............................... Credit for child and dependent care expenses .................................................... Credit for disabled access expenditures ... Expensing of costs of removing certain architectural barriers to the handicapped ................................................... Deductibility of charitable contributions, other than education and health ........... Exclusion of certain foster care payments Exclusion of parsonage allowances .......... Health: Exclusion of employer contributions for medical insurance premiums and medical care Self-employed medical insurance premiums Workers’ compensation insurance premiums Medical Savings Accounts ............................. Deductibility of medical expenses ................. Exclusion of interest on hospital construction bonds .......................................................... Deductibility of charitable contributions (health) ....................................................... Tax credit for orphan drug research ............. Special Blue Cross/Blue Shield deduction .... 1999 0 2000 10 2001 20 Individuals 2002 30 2003 35 2000– 2004 2004 35 35 ............ ............ ............ ............ ............ ............ ............ .............. ............ ............ ............ ............ ............ ............ ............ .............. 10 10 15 15 15 15 20 80 875 915 965 1,015 1,055 1,105 3,525 18,740 18,725 18,430 18,160 17,745 1,155 17,155 5,295 90,215 2,285 2,400 2,520 11,455 ............ ............ ............ ............ ............ ............ ............ .............. 215 215 210 15 0 0 0 225 145 285 280 135 35 5 0 455 15 30 30 15 10 5 0 60 ............ ............ ............ ............ ............ ............ ............ .............. ............ ............ ............ ............ ............ ............ ............ .............. 25 0 1,325 125 50 5 1,385 295 50 5 1,445 345 25 5 1,510 390 5 0 1,575 385 0 0 1,645 235 0 0 1,715 170 80 10 7,890 1,525 ............ ............ ............ ............ ............ ............ ............ .............. 620 650 680 710 740 775 810 3,715 ............ ............ ............ ............ ............ ............ ............ .............. 15 15 15 15 15 20 20 85 2,485 30 2,455 35 2,425 35 2,395 35 2,365 40 2,340 40 2,310 40 11,835 190 5 1,160 5 25 1,190 1,190 1,215 1,255 1,310 1,360 1,425 6,565 17,390 17,960 18,840 19,750 20,740 21,790 ............ ............ ............ ............ ............ ............ ............ .............. 35 35 40 40 45 45 ............ ............ ............ ............ ............ ............ ............ .............. 315 340 360 385 410 440 ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ .............. 67,920 72,535 77,670 83,095 88,830 94,960 101,520 446,075 .............. 765 980 1,310 1,405 1,550 2,055 2,905 9,225 .............. 4,260 4,420 4,585 4,755 4,935 5,120 5,315 24,710 .............. 15 20 25 25 20 20 15 105 .............. 3,615 3,775 3,985 4,215 4,475 4,750 5,035 22,460 305 305 310 310 315 320 320 1,575 610 40 210 610 50 230 620 55 250 640 60 280 670 70 325 695 80 290 730 90 250 3,355 1,950 2,020 2,110 2,220 2,330 2,450 2,570 11,680 355 ............ ............ ............ ............ ............ ............ .............. .............. 1,395 ............ ............ ............ ............ ............ ............ .............. .............. 855 865 875 880 890 900 114 115 116 117 118 119 120 121 Social Security: Exclusion of social security benefits: Social Security benefits for retired workers ............ ............ ............ ............ ............ ............ ............ .............. 16,780 17,210 18,125 19,045 20,100 21,260 Social Security benefits for disabled ......... ............ ............ ............ ............ ............ ............ ............ .............. 2,265 2,420 2,615 2,820 3,060 3,325 104 105 106 107 108 109 110 111 112 113 22,910 104,030 50 220 470 2,065 ............ ............ ............ ............ ............ Income security: Exclusion of railroad retirement system benefits ............................................................. Exclusion of workers’ compensation benefits Exclusion of public assistance benefits (normal tax method) ......................................... Exclusion of special benefits for disabled coal miners ................................................. Exclusion of military disability pensions ........ Net exclusion of pension contributions and earnings: Employer plans .......................................... Individual Retirement Accounts ................. Keogh plans ............................................... Exclusion of other employee benefits: Premiums on group term life insurance .... Premiums on accident and disability insurance ....................................................... Income of trusts to finance supplementary unemployment benefits .............................. Special ESOP rules ........................................ Additional deduction for the blind .................. Additional deduction for the elderly ............... Tax credit for the elderly and disabled ......... Deductibility of casualty losses ...................... Earned income tax credit 3 ............................. 103 2000– 2004 2004 2,175 5 1,105 2003 2,075 5 1,065 2002 1,970 5 1,020 2001 1,910 5 990 2000 5,340 0 970 1999 155 ............ ............ ............ ............ ............ ............ ............ .............. 970 1998 910 4,455 ............ ............ ............ ............ ............ ............ ............ .............. ............ ............ ............ ............ ............ ............ ............ .............. 420 5,140 420 5,330 425 5,475 425 5,940 430 6,205 435 6,480 440 6,755 2,155 30,855 ............ ............ ............ ............ ............ ............ ............ .............. 440 345 360 375 390 405 420 1,950 ............ ............ ............ ............ ............ ............ ............ .............. ............ ............ ............ ............ ............ ............ ............ .............. 85 120 80 125 75 130 70 135 70 140 65 140 60 145 340 690 ............ ............ ............ ............ ............ ............ ............ .............. 82,215 82,195 84,350 86,670 89,155 91,810 ............ ............ ............ ............ ............ ............ ............ .............. 10,565 10,770 11,170 11,440 11,550 11,485 ............ ............ ............ ............ ............ ............ ............ .............. 3,930 4,025 4,255 4,495 4,750 5,010 94,455 446,440 11,270 56,915 5,285 23,795 ............ ............ ............ ............ ............ ............ ............ .............. 2,030 2,075 2,120 2,170 2,220 2,270 2,335 11,115 ............ ............ ............ ............ ............ ............ ............ .............. 175 185 195 205 215 225 235 1,075 5 260 30 1,690 40 225 6,351 5 270 30 1,720 40 235 5,118 5 280 30 1,740 40 245 4,971 5 290 30 1,795 40 255 5,142 5 300 35 1,880 40 270 5,275 5 310 35 1,945 40 280 5,471 5 320 35 2,020 40 290 5,672 25 1,500 165 9,380 200 1,340 26,531 ............ 660 ............ ............ ............ ............ ............ ............ 680 ............ ............ ............ ............ ............ ............ 700 ............ ............ ............ ............ ............ ............ 730 ............ ............ ............ ............ ............ ............ 760 ............ ............ ............ ............ ............ ............ 790 ............ ............ ............ ............ ............ ............ 820 ............ ............ ............ ............ ............ .............. 3,800 .............. .............. .............. .............. .............. 22,460 100,990 3,625 15,445 113 5. TAX EXPENDITURES Table 5–2. CORPORATE AND INDIVIDUAL INCOME TAX REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES—Continued (In millions of dollars) Revenue Loss Corporations 1998 122 123 124 125 126 127 128 129 130 1999 2000 2001 2002 Individuals 2003 2004 2000– 2004 Social Security benefits for dependents and survivors ......................................... ............ ............ ............ ............ ............ ............ ............ .............. Veterans benefits and services: Exclusion of veterans death benefits and disability compensation .............................. ............ ............ ............ ............ ............ ............ ............ .............. Exclusion of veterans pensions ..................... ............ ............ ............ ............ ............ ............ ............ .............. Exclusion of GI bill benefits ........................... ............ ............ ............ ............ ............ ............ ............ .............. Exclusion of interest on veterans housing bonds .......................................................... 10 10 10 10 10 10 10 50 2004 2000– 2004 1998 1999 2000 2001 2002 2003 3,725 3,785 3,910 4,065 4,235 4,405 4,575 21,190 2,820 65 65 2,940 65 75 3,070 70 85 3,210 75 90 3,350 80 90 3,495 85 95 3,650 85 100 16,775 395 460 30 30 30 30 30 30 30 150 General purpose fiscal assistance: Exclusion of interest on public purpose bonds .......................................................... 5,240 5,295 5,345 5,400 5,455 5,510 5,565 27,275 14,810 14,955 15,105 15,260 15,410 15,565 15,720 77,060 Deductibility of nonbusiness State and local taxes other than on owner-occupied homes ......................................................... ............ ............ ............ ............ ............ ............ ............ .............. 32,795 34,925 37,000 39,235 41,715 44,490 47,400 209,840 Tax credit for corporations receiving income from doing business in U.S. possessions 3,960 4,000 4,120 4,245 4,285 4,150 4,215 21,015 ............ ............ ............ ............ ............ ............ .............. .............. Interest: Deferral of interest on U.S. savings bonds ... ............ ............ ............ ............ ............ ............ ............ .............. 965 1,015 1,065 1,115 1,175 1,235 Addendum—Aid to State and local governments: Deductibility of: Property taxes on owner-occupied homes ............ ............ ............ ............ ............ ............ ............ .............. 17,770 18,595 19,495 20,535 21,625 22,635 Nonbusiness State and local taxes other than on owner-occupied homes ............ ............ ............ ............ ............ ............ ............ ............ .............. 32,795 34,925 37,000 39,235 41,715 44,490 Exclusion of interest on: Public purpose State and local debt ......... 5,240 5,295 5,345 5,400 5,455 5,510 5,565 27,275 14,810 14,955 15,105 15,260 15,410 15,565 IDBs for certain energy facilities ............... 30 30 30 30 30 30 30 150 80 80 80 85 85 85 IDBs for pollution control and sewage and waste disposal facilities ......................... 115 115 115 120 120 120 120 595 325 325 330 335 335 340 Small-issue IDBs ........................................ 75 80 80 80 80 80 80 400 220 220 225 225 225 230 Owner-occupied mortgage revenue bonds 225 230 230 230 235 235 240 1,170 635 645 650 655 665 670 State and local debt for rental housing .... 40 40 40 40 40 40 40 200 110 110 110 110 115 115 IDBs for airports, docks, and sports and convention facilities ................................ 180 185 185 185 190 190 195 945 515 520 525 530 535 540 State and local student loan bonds .......... 60 60 65 65 65 65 65 325 175 175 175 180 180 185 State and local debt for private nonprofit educational facilities ............................... 145 150 150 150 150 155 155 760 415 420 420 425 430 435 State and local debt for private nonprofit health facilities ....................................... 305 305 310 310 315 320 320 1,575 855 865 875 880 890 900 State and local debt for veterans housing 10 10 10 10 10 10 10 50 30 30 30 30 30 30 1,295 5,885 23,645 107,935 47,400 209,840 15,720 85 77,060 420 345 230 675 115 1,685 1,135 3,315 565 545 185 2,675 905 440 2,150 910 30 4,455 150 1 In addition, the partial exemption from the excise tax for alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1998 $680; 1999 $725; 2000 $755; 2001 $765; 2002 $790; 2003 $805; and 2004 $830. 2 The figures in the table indicate the effect of the child tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $0; 1999 $415; 2000 $528; 2001 $496; 2002 $483; 2003 $453; and 2004 $425. 3 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $23,239; 1999 $26,273; 2000 $26,882; 2001 $27,667; 2002 $28,632; 2003 $29,566; and 2004 $30,578. Note: Provisions with estimates denoted normal tax method have no revenue loss under the reference tax law method. All estimates have been rounded to the nearest $5 million. Provisions with estimates that rounded to zero in each year are not included in the table. 114 ANALYTICAL PERSPECTIVES Table 5–3. MAJOR TAX EXPENDITURES IN THE INCOME TAX, RANKED BY TOTAL 2000 REVENUE LOSS (In millions of dollars) Provision 2000 Net exclusion of pension contributions and earnings: Employer plans ......................................................................... Exclusion of employer contributions for medical insurance premiums and medical care ............................................ Deductibility of mortgage interest on owner-occupied homes ....................................................................................... Capital gains (except agriculture, timber, iron ore, and coal) (normal tax method) ..................................................... Deductibility of nonbusiness State and local taxes other than on owner-occupied homes ......................................... Accelerated depreciation of machinery and equipment (normal tax method) ............................................................... Step-up basis of capital gains at death .......................................................................................................................... Deductibility of charitable contributions, total .................................................................................................................. Exclusion of interest on public purpose bonds .............................................................................................................. Deductibility of State and local property tax on owner-occupied homes ...................................................................... Child credit 2 ..................................................................................................................................................................... Capital gains exclusion on home sales .......................................................................................................................... Exclusion of Social Security benefits for retired workers ............................................................................................... Exclusion of interest on life insurance savings .............................................................................................................. Net exclusion of pension contributions and earnings: Individual Retirement Accounts ............................................... Deferral of income from controlled foreign corporations (normal tax method) ............................................................. Exclusion of workers’ compensation benefits ................................................................................................................. Graduated corporation income tax rate (normal tax method) ........................................................................................ Earned income tax credit 3 .............................................................................................................................................. HOPE tax credit ............................................................................................................................................................... Exclusion of interest on non-public purpose State and local debt ................................................................................ Workers’ compensation insurance premiums ................................................................................................................. Net exclusion of pension contributions and earnings: Keogh plans .............................................................................. Exception from passive loss rules for $25,000 of rental loss ....................................................................................... Tax credit for corporations receiving income from doing business in U.S. possessions ............................................. Deductibility of medical expenses ................................................................................................................................... Exclusion of Social Security benefits for dependents and survivors ............................................................................. Accelerated depreciation of buildings other than rental housing (normal tax method) ................................................ Credit for low-income housing investments .................................................................................................................... Accelerated depreciation on rental housing (normal tax method) ................................................................................. Exclusion of veterans death benefits and disability compensation ............................................................................... Lifetime Learning tax credit ............................................................................................................................................. Exclusion of Social Security benefits for disabled ......................................................................................................... Exclusion of income earned abroad by U.S. citizens .................................................................................................... Credit for child and dependent care expenses .............................................................................................................. Exclusion of income of foreign sales corporations ......................................................................................................... Exclusion of benefits and allowances to armed forces personnel ................................................................................ Exclusion of other employee benefits: Premiums on group term life insurance .......................................................... Additional deduction for the elderly ................................................................................................................................. Exclusion of reimbursed employee parking expenses ................................................................................................... Exclusion of employer-provided child care ..................................................................................................................... Self-employed medical insurance premiums .................................................................................................................. Expensing of certain small investments (normal tax method) ....................................................................................... Inventory property sales source rules exception ............................................................................................................ Deferral of interest on U.S. savings bonds .................................................................................................................... Deferral of income from post-1987 installment sales ..................................................................................................... Exclusion of scholarship and fellowship income (normal tax method) .......................................................................... Credit for increasing research activities .......................................................................................................................... Special ESOP rules ......................................................................................................................................................... Parental personal exemption for students age 19 or over ............................................................................................ Exemption of credit union income ................................................................................................................................... Alternative fuel production credit ..................................................................................................................................... Exclusion of employee meals and lodging (other than military) .................................................................................... Capital gains treatment of certain income ...................................................................................................................... Expensing of research and experimentation expenditures (normal tax method) .......................................................... Expensing of multiperiod timber growing costs .............................................................................................................. Excess of percentage over cost depletion, fuels and nonfuel minerals ........................................................................ Empowerment zones and enterprise communities ......................................................................................................... Exclusion of railroad retirement system benefits ............................................................................................................ Exclusion of parsonage allowances ................................................................................................................................ Exclusion of public assistance benefits (normal tax method) ........................................................................................ Adoption assistance ......................................................................................................................................................... Work opportunity tax credit ............................................................................................................................................. Deductibility of student-loan interest ............................................................................................................................... Tax incentives for preservation of historic structures ..................................................................................................... Special Blue Cross/Blue Shield deduction ...................................................................................................................... Deductibility of casualty losses ....................................................................................................................................... Tax exemption of certain insurance companies owned by tax-exempt organizations .................................................. Education Individual Retirement Accounts ...................................................................................................................... 84,350 77,670 55,100 40,585 37,000 35,465 27,090 25,850 20,450 19,495 18,725 18,540 18,125 14,990 11,170 6,200 5,475 5,360 4,971 4,855 4,635 4,585 4,255 4,215 4,120 3,985 3,910 3,430 3,335 3,095 3,070 2,655 2,615 2,500 2,425 2,400 2,140 2,120 1,740 1,630 1,445 1,310 1,275 1,100 1,065 1,015 995 980 980 965 905 760 680 655 510 510 510 430 425 360 360 345 330 265 255 250 245 240 230 2000–2004 446,440 446,075 303,145 215,350 209,840 181,645 147,010 142,425 104,335 107,935 90,215 98,435 100,990 83,915 56,915 35,150 30,855 30,900 26,531 27,625 23,625 24,710 23,795 18,950 21,015 22,460 21,190 10,640 17,595 20,920 16,775 16,560 15,445 15,715 11,835 13,650 10,900 11,115 9,380 8,770 7,890 9,225 6,780 6,300 5,885 5,275 5,440 1,645 5,300 5,295 5,235 2,715 3,715 3,590 3,295 2,750 2,725 1,875 2,155 2,065 1,950 1,525 535 1,750 1,435 1,395 1,340 1,410 2,745 115 5. TAX EXPENDITURES Table 5–3. MAJOR TAX EXPENDITURES IN THE INCOME TAX, RANKED BY TOTAL 2000 REVENUE LOSS— Continued (In millions of dollars) Provision Amortization of start-up costs (normal tax method) ....................................................................................................... Exclusion of employer-provided educational assistance ................................................................................................ Exclusion of other employee benefits: Premiums on accident and disability insurance .............................................. Carryover basis of capital gains on gifts ........................................................................................................................ Deferral for State prepaid tuition plans ........................................................................................................................... Enhanced oil recovery credit ........................................................................................................................................... Exceptions from imputed interest rules ........................................................................................................................... Expensing of environmental remediation costs .............................................................................................................. Exclusion of military disability pensions .......................................................................................................................... Small life insurance company deduction ........................................................................................................................ Exclusion for employer-provided transit passes ............................................................................................................. Tax credit and deduction for clean-fuel burning vehicles .............................................................................................. Exclusion of GI bill benefits ............................................................................................................................................. Expensing of certain multiperiod production costs ......................................................................................................... Exclusion from income of conservation subsidies provided by public utilities .............................................................. Exclusion of special benefits for disabled coal miners .................................................................................................. Income averaging for farmers ......................................................................................................................................... Exclusion of veterans pensions ....................................................................................................................................... Expensing of certain capital outlays ............................................................................................................................... Capital gains treatment of certain timber income .......................................................................................................... Deferred taxes for financial firms on certain income earned overseas ........................................................................ Capital gains treatment of royalties on coal ................................................................................................................... Tax credit for orphan drug research ............................................................................................................................... Credit for disabled access expenditures ......................................................................................................................... Exemption of certain mutuals’ and cooperatives’ income .............................................................................................. Exclusion of certain foster care payments ...................................................................................................................... Tax credit for the elderly and disabled ........................................................................................................................... Exception from passive loss limitation for working interests in oil and gas properties ................................................ New technology credit ..................................................................................................................................................... Ordinary income treatment of loss from small business corporation stock sale .......................................................... Welfare-to-work tax credit ................................................................................................................................................ Investment credit for rehabilitation of structures (other than historic) ........................................................................... Additional deduction for the blind .................................................................................................................................... Medical Savings Accounts ............................................................................................................................................... Expensing of exploration and development costs, nonfuel minerals ............................................................................. Cancellation of indebtedness .......................................................................................................................................... Credit for holders of zone academy bonds .................................................................................................................... Deferral of tax on shipping companies ........................................................................................................................... Exclusion of interest on savings bonds redeemed to finance educational expenses .................................................. Alcohol fuel credits 1 ........................................................................................................................................................ Treatment of loans forgiven for solvent farmers ............................................................................................................ Excess bad debt reserves of financial institutions ......................................................................................................... Deferral of gain on sale of farm refiners ........................................................................................................................ Investment credit and seven-year amortization for reforestation expenditures ............................................................. Capital gains exclusion of small corporation stock ........................................................................................................ Expensing of costs of removing certain architectural barriers to the handicapped ...................................................... Income of trusts to finance supplementary unemployment benefits ............................................................................. Special alternative tax on small property and casualty insurance companies ............................................................. Expensing of exploration and development costs, fuels ................................................................................................ 2000 220 210 195 185 180 180 160 145 130 100 95 90 85 85 80 75 75 70 70 65 65 65 55 50 50 40 40 35 35 35 35 30 30 25 25 20 20 15 15 15 10 10 10 10 5 5 5 5 (10) 2000–2004 1,140 225 1,075 1,015 1,395 1,225 815 135 690 520 655 410 460 475 385 340 400 395 385 360 65 360 355 275 255 220 200 190 185 195 70 150 165 105 135 100 155 75 80 75 50 25 60 65 25 25 25 25 45 1 In addition, the partial exemption from the excise tax for alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1998 $680; 1999 $725; 2000 $755; 2001 $765; 2002 $790; 2003 $805; and 2004 $830 2 The figures in the table indicate the effect of the child tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $0; 1999 $415; 2000 $528; 2001 $496; 2002 $483; 2003 $453; and 2004 $425. 3 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $23,239; 1999 $26,273; 2000 $26,882; 2001 $27,667; 2002 $28,632; 2003 $29,566; and 2004 $30,578. Note: Provisions with estimates denoted ‘‘normal tax method’’ have no revenue loss under the reference tax law method. All estimates have been rounded to the nearest $5 million. Provisions with estimates that rounded to zero in each year are not included in the able. Note: Three categories in the table are aggregated: Deductibility of chartable contributions, exclusion of interest for non-public purpose State and local debt, and excess of percentage over cost depletion, fuels and nonfuel minerals. 116 ANALYTICAL PERSPECTIVES Table 5–4. PRESENT VALUE OF SELECTED TAX EXPENDITURES FOR ACTIVITY IN CALENDAR YEAR 1998 (In millions of dollars) Present Value of Revenue Loss Provision 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Deferral of income from controlled foreign corporations (normal tax method) .................................................. Deferred taxes for financial firms on income earned overseas .......................................................................... Expensing of research and experimentation expenditures (normal tax method) ............................................... Expensing of exploration and development costs—fuels .................................................................................... Expensing of exploration and development costs—nonfuels .............................................................................. Expensing of multiperiod timber growing costs ................................................................................................... Expensing of certain multiperiod production costs—agriculture .......................................................................... Expensing of certain capital outlays—agriculture ................................................................................................ Deferral of income on life insurance and annuity contracts ............................................................................... Accelerated depreciation of rental housing (normal tax method) ....................................................................... Accelerated depreciation of buildings other than rental housing (normal tax method) ..................................... Accelerated depreciation of machinery and equipment (normal tax method) .................................................... Expensing of certain small investments (normal tax method) ............................................................................ Amortization of start-up costs (normal tax method) ............................................................................................ Deferral of tax on shipping companies ................................................................................................................ Credit for holders of zone academy bonds ......................................................................................................... Credit for low-income housing investments ......................................................................................................... Exclusion of pension contributions—employer plans ........................................................................................... Exclusion of IRA contributions and earnings ....................................................................................................... Exclusion of contributions and earnings for Keogh plans ................................................................................... Exclusion of interest on public-purpose bonds .................................................................................................... Exclusion of interest on non-public purpose bonds ............................................................................................ Deferral of interest on U.S. savings bonds ......................................................................................................... Outlay Equivalents The concept of ‘‘outlay equivalents’’ complements ‘‘revenue losses’’ as a measure of the budget effect of tax expenditures. It is the amount of outlay that would be required to provide the taxpayer the same aftertax income as would be received through the tax preference. The outlay equivalent measure allows a comparison of the cost of the tax expenditure with that of a direct Federal outlay. Outlay equivalents are reported in table 5–5. The measure is larger than the revenue loss estimate when the tax expenditure is judged to function as a Government payment for service. This occurs because 5,700 550 1,650 90 20 250 90 75 20,615 3,415 560 39,670 1,375 180 15 180 2,745 84,430 13,285 3,555 22,360 3,435 390 an outlay program would increase the taxpayer’s pretax income. For some tax expenditures, however, the revenue loss equals the outlay equivalent measure. This occurs when the tax expenditure is judged to function like a price reduction or tax deferral that does not directly enter the taxpayer’s pre-tax income.1 1 Budget outlay figures generally reflect the pre-tax price of the resources. In some instances, however, Government purchases or subsidies are exempted from tax by a special tax provision. When this occurs, the outlay figure understates the resource cost of the program and is, therefore, not comparable with other outlay amounts. For example, the outlays for certain military personnel allowances are not taxed. If this form of compensation were treated as part of the employee’s taxable income, the Defense Department would have to make larger cash payments to its military personnel to leave them as well off after tax as they are now. The tax subsidy must be added to the tax-exempt budget outlay to make this element of national defense expenditures comparable with other outlays. 117 5. TAX EXPENDITURES Table 5–5. OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX (In millions of dollars) Outlay Equivalents 1998 1999 2000 2001 2002 2003 2004 2000–2004 1 National Defense: Exclusion of benefits and allowances to armed forces personnel .......................................................... 2,445 2,470 2,495 2,520 2,545 2,570 2,595 12,725 2 3 4 5 6 International affairs: Exclusion of income earned abroad by U.S. citizens ............................................................................. Exclusion of income of foreign sales corporations .................................................................................. Inventory property sales source rules exception ..................................................................................... Deferral of income from controlled foreign corporations (normal tax method) ....................................... Deferred taxes for financial firms on income earned overseas .............................................................. 2,640 3,310 1,550 5,500 400 2,965 3,460 1,620 5,800 1,075 3,315 3,700 1,690 6,200 65 3,710 3,920 1,770 6,600 0 4,145 4,150 1,920 7,000 0 4,590 4,460 2,080 7,450 0 5,080 4,770 2,230 7,900 0 20,840 21,000 9,690 35,150 65 7 8 General science, space, and technology: Expensing of research and experimentation expenditures (normal tax method) ................................... Credit for increasing research activities ................................................................................................... 260 3,270 330 2,550 510 1,500 610 650 675 275 735 90 765 15 3,295 2,530 9 10 11 12 13 14 15 16 17 18 19 Energy: Expensing of exploration and development costs, fuels ......................................................................... Excess of percentage over cost depletion, fuels ..................................................................................... Alternative fuel production credit .............................................................................................................. Exception from passive loss limitation for working interests in oil and gas properties ......................... Capital gains treatment of royalties on coal ............................................................................................ Exclusion of interest on energy facility bonds ......................................................................................... Enhanced oil recovery credit .................................................................................................................... New technology credit ............................................................................................................................... Alcohol fuel credits 1 ................................................................................................................................. Tax credit and deduction for clean-fuel burning vehicles ....................................................................... Exclusion from income of conservation subsidies provided by public utilities ....................................... (130) 285 1,100 30 80 155 215 30 15 95 110 (90) 295 1,030 35 85 155 245 40 15 105 110 (20) 300 975 35 85 155 285 45 15 115 105 (25) 310 915 35 95 165 325 50 15 130 105 0 320 860 40 95 165 375 55 15 120 100 40 325 555 40 100 165 425 55 15 95 105 45 335 165 40 105 165 490 40 15 65 105 40 1,590 3,470 190 480 815 1,900 245 75 525 520 20 21 22 23 24 25 26 Natural resources and environment: Expensing of exploration and development costs, nonfuel minerals ...................................................... Excess of percentage over cost depletion, nonfuel minerals ................................................................. Exclusion of interest on bonds for water, sewage, and hazardous waste facilities .............................. Capital gains treatment of certain timber income .................................................................................... Expensing of multiperiod timber growing costs ....................................................................................... Investment credit and seven-year amortization for reforestation expenditures ...................................... Tax incentives for preservation of historic structures .............................................................................. 30 275 630 80 485 15 215 30 280 630 85 500 15 235 30 300 640 85 510 15 255 30 310 650 95 530 15 275 30 325 650 95 550 15 285 40 340 655 100 570 15 305 40 350 665 105 590 15 315 170 1,625 3,260 480 2,750 75 1,435 27 28 29 30 31 32 Agriculture: Expensing of certain capital outlays ......................................................................................................... Expensing of certain multiperiod production costs .................................................................................. Treatment of loans forgiven for solvent farmers ...................................................................................... Capital gains treatment of certain income ............................................................................................... Income averaging for farmers ................................................................................................................... Deferral of gain on sale of farm refiners ................................................................................................. 65 80 10 805 10 10 70 85 10 840 75 10 70 85 10 875 75 10 75 90 10 915 80 10 75 95 10 955 80 10 80 100 10 1,000 80 15 85 105 10 1,045 85 15 385 475 50 4,790 400 60 1,000 70 13,465 5 290 140 1,070 30 14,200 5 315 140 1,150 10 14,990 5 335 140 1,235 5 15,810 5 345 150 1,325 5 16,680 5 365 150 1,425 5 17,595 5 415 150 1,530 0 18,840 5 450 150 6,665 25 83,915 25 1,910 740 1,230 215 51,700 17,770 975 21,845 4,735 4,065 2,405 1,255 215 52,990 18,595 995 22,500 4,455 4,210 2,740 1,260 215 55,100 19,495 1,015 23,175 4,215 4,340 3,095 1,270 215 57,590 20,535 1,035 23,870 4,000 4,540 4,170 1,290 220 60,415 21,625 1,055 24,590 3,785 4,610 4,590 1,295 220 63,425 22,635 1,075 25,325 3,575 4,720 4,495 1,315 220 66,615 23,645 1,095 26,090 3,375 4,705 4,570 6,430 1,090 303,145 107,935 5,275 123,050 18,950 22,915 20,920 50 155 51,035 0 32,760 170 45 6,270 30 160 52,555 5 34,400 175 45 4,895 20 160 54,115 5 36,120 185 45 3,430 15 160 55,725 5 37,655 195 55 2,385 20 165 57,380 5 39,160 205 55 2,365 20 165 59,080 5 40,725 210 55 1,875 25 165 60,835 5 42,355 220 55 585 100 815 287,135 25 196,015 1,015 265 10,640 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 Commerce and housing: Financial institutions and insurance: Exemption of credit union income ....................................................................................................... Excess bad debt reserves of financial institutions .............................................................................. Exclusion of interest on life insurance savings ................................................................................... Special alternative tax on small property and casualty insurance companies .................................. Tax exemption of certain insurance companies owned by tax-exempt organizations ...................... Small life insurance company deduction ............................................................................................. Housing: Exclusion of interest on owner-occupied mortgage subsidy bonds .................................................... Exclusion of interest on rental housing bonds .................................................................................... Deductibility of mortgage interest on owner-occupied homes ............................................................ Deductibility of State and local property tax on owner-occupied homes ........................................... Deferral of income from post-1987 installment sales .......................................................................... Capital gains exclusion on home sales ............................................................................................... Exception from passive loss rules for $25,000 of rental loss ............................................................ Credit for low-income housing investments ......................................................................................... Accelerated depreciation on rental housing (normal tax method) ...................................................... Commerce: Cancellation of indebtedness ............................................................................................................... Exceptions from imputed interest rules ............................................................................................... Capital gains (except agriculture, timber, iron ore, and coal) (normal tax method) .......................... Capital gains exclusion of small corporation stock ............................................................................. Step-up basis of capital gains at death ............................................................................................... Carryover basis of capital gains on gifts ............................................................................................. Ordinary income treatment of loss from small business corporation stock sale ............................... Accelerated depreciation of buildings other than rental housing (normal tax method) ..................... 118 ANALYTICAL PERSPECTIVES Table 5–5. OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued (In millions of dollars) Outlay Equivalents 1998 1999 2000 2001 2002 2003 2004 2000–2004 56 57 58 59 60 Accelerated depreciation of machinery and equipment (normal tax method) .................................... Expensing of certain small investments (normal tax method) ............................................................ Amortization of start-up costs (normal tax method) ............................................................................ Graduated corporation income tax rate (normal tax method) ............................................................. Exclusion of interest on small issue bonds ......................................................................................... 28,885 1,185 205 7,400 425 32,505 1,235 215 7,340 430 35,465 1,275 220 7,340 435 36,830 1,175 225 7,700 435 36,985 1,730 225 8,385 435 36,510 1,605 230 9,150 445 35,855 995 240 9,755 445 181,645 6,780 1,140 42,330 2,195 61 62 63 Transportation: Deferral of tax on shipping companies .................................................................................................... Exclusion of reimbursed employee parking expenses ............................................................................ Exclusion for employer-provided transit passes ...................................................................................... 20 2,010 95 20 2,060 115 20 2,105 130 20 2,180 150 20 2,260 180 20 2,345 215 20 2,430 240 100 11,320 915 64 65 66 67 68 Community and regional development: Investment credit for rehabilitation of structures (other than historic) .................................................... Exclusion of interest for airport, dock, and similar bonds ....................................................................... Exemption of certain mutuals’ and cooperatives’ income ....................................................................... Empowerment zones and enterprise communities .................................................................................. Expensing of environmental remediation costs ....................................................................................... 30 995 45 290 120 30 1,010 50 380 145 30 1,015 50 430 195 30 1,025 50 435 80 30 1,040 50 415 (15) 30 1,045 50 305 (35) 30 1,060 55 290 (45) 150 5,185 255 1,875 180 1,015 255 140 25 90 85 340 800 0 15 970 4,700 3,995 270 1,060 5,150 3,215 125 305 125 340 820 15 15 1,010 24,985 4,090 270 1,105 6,225 3,405 295 330 180 345 820 30 20 1,070 24,965 4,250 260 1,155 6,830 3,805 480 390 235 350 825 45 20 1,125 24,575 4,435 20 1,210 7,345 3,865 685 450 285 350 835 50 20 1,165 24,215 4,650 0 1,265 7,390 4,305 895 485 330 360 845 50 20 1,225 23,660 4,870 0 1,320 7,625 5,850 1,120 530 365 360 850 50 30 1,280 22,875 5,125 0 6,055 35,415 21,230 3,475 2,185 1,395 1,765 4,175 225 110 5,865 120,290 23,330 280 83 84 85 86 87 88 89 90 91 92 93 Education, training, employment, and social services: Education: Exclusion of scholarship and fellowship income (normal tax method) ............................................... HOPE tax credit .................................................................................................................................... Lifetime Learning tax credit .................................................................................................................. Education Individual Retirement Accounts ........................................................................................... Deductibility of student-loan interest .................................................................................................... Deferral for State prepaid tuition plans ................................................................................................ Exclusion of interest on student-loan bonds ....................................................................................... Exclusion of interest on bonds for private nonprofit educational facilities ......................................... Credit for holders of zone academy bonds ......................................................................................... Exclusion of interest on savings bonds redeemed to finance educational expenses ....................... Parental personal exemption for students age 19 or over ................................................................. Child credit 2 .......................................................................................................................................... Deductibility of charitable contributions (education) ............................................................................ Exclusion of employer-provided educational assistance ..................................................................... Training, employment, and social services: Work opportunity tax credit .................................................................................................................. Welfare-to-work tax credit ..................................................................................................................... Exclusion of employer-provided child care .......................................................................................... Adoption assistance .............................................................................................................................. Exclusion of employee meals and lodging (other than military) ......................................................... Credit for child and dependent care expenses ................................................................................... Credit for disabled access expenditures .............................................................................................. Expensing of costs of removing certain architectural barriers to the handicapped ........................... Deductibility of charitable contributions, other than education and health ......................................... Exclusion of certain foster care payments .......................................................................................... Exclusion of parsonage allowances ..................................................................................................... 170 15 1,765 155 760 3,315 60 0 25,000 45 390 335 35 1,845 355 795 3,275 65 5 25,780 45 415 330 35 1,925 415 830 3,235 65 5 27,015 50 445 160 20 2,015 470 865 3,195 65 5 28,320 50 475 40 10 2,100 460 905 3,155 75 5 29,770 50 505 5 5 2,195 285 945 3,115 80 5 31,310 55 540 0 0 2,285 205 990 3,080 85 5 32,980 60 580 535 70 10,520 1,835 4,535 15,780 370 25 149,395 265 2,545 94 95 96 97 98 99 100 101 102 Health: Exclusion of employer contributions for medical insurance premiums and medical care ..................... Self-employed medical insurance premiums ............................................................................................ Workers’ compensation insurance premiums ........................................................................................... Medical Savings Accounts ........................................................................................................................ Deductibility of medical expenses ............................................................................................................ Exclusion of interest on hospital construction bonds .............................................................................. Deductibility of charitable contributions (health) ...................................................................................... Tax credit for orphan drug research ........................................................................................................ Special Blue Cross/Blue Shield deduction ............................................................................................... 86,925 935 5,320 20 3,615 1,665 3,520 60 280 92,985 1,195 5,520 30 3,775 1,680 3,600 75 310 99,735 1,600 5,730 30 3,985 1,695 3,760 80 335 106,890 1,715 5,945 35 4,215 1,705 3,930 90 375 114,465 1,890 6,170 30 4,475 1,725 4,120 105 435 122,580 2,505 6,400 30 4,750 1,750 4,330 115 385 131,280 3,545 6,645 25 5,035 1,765 4,560 130 335 574,950 11,255 30,890 150 22,460 8,640 20,700 520 1,865 420 5,140 440 85 120 420 5,330 345 80 125 425 5,475 360 75 130 425 5,940 375 70 135 430 6,205 390 70 140 435 6,480 405 65 140 440 6,755 420 60 145 2,155 30,855 1,950 340 690 106,170 14,115 5,010 106,840 14,475 5,105 109,760 15,095 5,400 112,750 15,570 5,705 116,015 15,855 6,025 119,475 15,940 6,360 122,975 15,845 6,710 580,975 78,305 30,200 2,690 2,750 2,815 2,880 2,945 3,015 3,085 14,740 69 70 71 72 73 74 75 76 77 78 79 80 81 82 103 104 105 106 107 108 109 110 111 Income security: Exclusion of railroad retirement system benefits ..................................................................................... Exclusion of workers’ compensation benefits .......................................................................................... Exclusion of public assistance benefits (normal tax method) ................................................................. Exclusion of special benefits for disabled coal miners ........................................................................... Exclusion of military disability pensions ................................................................................................... Net exclusion of pension contributions and earnings: Employer plans ..................................................................................................................................... Individual Retirement Accounts ............................................................................................................ Keogh plans .......................................................................................................................................... Exclusion of other employee benefits: Premiums on group term life insurance .............................................................................................. 119 5. TAX EXPENDITURES Table 5–5. OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued (In millions of dollars) Outlay Equivalents 1998 1999 2000 2001 2002 2003 2004 2000–2004 112 113 114 115 116 117 118 119 Premiums on accident and disability insurance .................................................................................. Income of trusts to finance supplementary unemployment benefits ....................................................... Special ESOP rules .................................................................................................................................. Additional deduction for the blind ............................................................................................................. Additional deduction for the elderly .......................................................................................................... Tax credit for the elderly and disabled .................................................................................................... Deductibility of casualty losses ................................................................................................................. Earned income tax credit 3 ....................................................................................................................... 225 5 1,280 35 2,045 50 245 7,056 235 5 1,320 35 2,085 50 260 5,687 250 5 1,360 35 2,105 50 270 5,523 260 5 1,415 35 2,175 50 285 5,714 275 5 1,470 40 2,275 50 295 5,861 290 5 1,530 40 2,355 50 310 6,079 305 5 1,585 45 2,440 55 320 6,303 1,380 25 7,360 195 11,350 255 1,480 29,480 120 121 122 Social Security: Exclusion of social security benefits: Social Security benefits for retired workers ......................................................................................... Social Security benefits for disabled .................................................................................................... Social Security benefits for dependents and survivors ....................................................................... 16,780 2,265 3,725 17,210 2,420 3,785 18,125 2,615 3,910 19,045 2,820 4,065 20,100 3,060 4,235 21,260 3,325 4,405 22,460 3,625 4,575 100,990 15,445 21,190 123 124 125 126 Veterans benefits and services: Exclusion of veterans death benefits and disability compensation ......................................................... Exclusion of veterans pensions ................................................................................................................ Exclusion of GI bill benefits ...................................................................................................................... Exclusion of interest on veterans housing bonds .................................................................................... 2,820 65 65 60 2,940 65 75 60 3,070 70 85 60 3,210 75 90 60 3,350 80 90 60 3,495 85 95 60 3,650 85 100 60 16,775 395 460 300 127 128 129 General purpose fiscal assistance: Exclusion of interest on public purpose bonds ........................................................................................ Deductibility of nonbusiness State and local taxes other than on owner-occupied homes .................. Tax credit for corporations receiving income from doing business in U.S. possessions ...................... 28,720 32,795 3,960 29,005 34,925 4,000 29,290 37,000 4,120 29,595 39,235 4,245 29,890 41,715 4,285 30,190 44,490 4,150 30,490 47,400 4,215 149,455 209,840 21,015 130 Interest: Deferral of interest on U.S. savings bonds .............................................................................................. 965 1,015 1,065 1,115 1,175 1,235 1,295 5,885 17,770 32,795 18,595 34,925 19,495 37,000 20,535 39,235 21,625 41,715 22,635 44,490 23,645 47,400 107,935 209,840 28,720 155 630 425 1,230 215 995 340 800 1,665 60 29,005 155 630 430 1,255 215 1,010 340 820 1,680 60 29,290 155 640 435 1,260 215 1,015 345 820 1,695 60 29,595 165 650 435 1,270 215 1,025 350 825 1,705 60 29,890 165 650 435 1,290 220 1,040 350 835 1,725 60 30,190 165 655 445 1,295 220 1,045 360 845 1,750 60 30,490 165 665 445 1,315 220 1,060 360 850 1,765 60 149,455 815 3,260 2,195 6,430 1,090 5,185 1,765 4,175 8,640 300 Addendum—Aid to State and local governments: Deductibility of: Property taxes on owner-occupied homes .......................................................................................... Nonbusiness State and local taxes other than on owner-occupied homes ....................................... Exclusion of interest on: Public purpose State and local debt .................................................................................................... IDBs for certain energy facilities .......................................................................................................... IDBs for pollution control and sewage and waste disposal facilities ................................................. Small-issue IDBs ................................................................................................................................... Owner-occupied mortgage revenue bonds .......................................................................................... State and local debt for rental housing ............................................................................................... IDBs for airports, docks, and sports and convention facilities ........................................................... State and local student loan bonds ..................................................................................................... State and local debt for private nonprofit educational facilities .......................................................... State and local debt for private nonprofit health facilities .................................................................. State and local debt for veterans housing .......................................................................................... 1 In addition, the partial exemption from the excise tax for alcohol fuels results in a reduction in excise tax receipts (in millions of dollars) as follows: 1998 $680; 1999 $725; 2000 $755; 2001 $765; 2002 $790; 2003 $805; and 2004 $830. 2 The figures in the table indicate the effect of the child tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $0; 1999 $415; 2000 $528; 2001 $496; 2002 $483; 2003 $453; and 2004 $425. 3 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect on outlays (in millions of dollars) is as follows: 1998 $23,240; 1999 $25,650; 2000 $26,525; 2001 $27,265; 2002 $27,975; 2003 $28,705; and 2004 $29,655. Note: Provisions with estimates denoted normal tax method have no revenue loss under the reference tax law method. All estimates have been rounded to the nearest $5 million. Provisions with estimates that rounded to zero in each year are not included in the table. Tax Expenditure Baselines A tax expenditure is a preferential exception to the baseline provisions of the tax structure. The 1974 Congressional Budget Act does not, however, specify the baseline provisions of the tax law. Deciding whether provisions are preferential exceptions, therefore, is a matter of judgement. As in prior years, this year’s tax expenditure estimates are presented using two baselines: the normal tax baseline, which is used by the Joint Committee on Taxation, and the reference tax law baseline, which has been reported by the Administration since 1983. The normal tax baseline is patterned on a comprehensive income tax, which defines income as the sum of consumption and the change in net wealth in a given period of time. The normal tax baseline allows personal exemptions, a standard deduction, and deductions of the expenses incurred in earning income. It is not limited to a particular structure of tax rates, or by a specific definition of the taxpaying unit. The reference tax law baseline is also patterned on a comprehensive income tax, but in practice is closer to existing law. Reference law tax expenditures are limited to special exceptions in the tax code that serve 120 programmatic functions. These functions correspond to specific budget categories such as national defense, agriculture, or health care. While tax expenditures under the reference law baseline are generally tax expenditures under the normal tax baseline, the reverse is not always true. Both the normal and reference tax baselines allow several major departures from a pure comprehensive income tax. For example: • Income is taxable when realized in exchange. Thus, neither the deferral of tax on unrealized capital gains nor the tax exclusion of imputed income (such as the rental value of owner-occupied housing or farmers’ consumption of their own produce) is regarded as a tax expenditure. Both accrued and imputed income would be taxed under a comprehensive income tax. • There is a separate corporation income tax. Under a comprehensive income tax, corporate income would be taxed only once—at the shareholder level, whether or not distributed in the form of dividends. • Values of assets and debt are not adjusted for inflation. A comprehensive income tax would adjust the cost basis of capital assets and debt for changes in the price level during the time the assets or debt are held. Thus, under a comprehensive income tax baseline, the failure to take account of inflation in measuring depreciation, capital gains, and interest income would be regarded as a negative tax expenditure (i.e., a tax penalty), and failure to take account of inflation in measuring interest costs would be regarded as a positive tax expenditure (i.e., a tax subsidy). While the reference law and normal tax baselines are generally similar, areas of difference include: • Tax rates. The separate schedules applying to the various taxpaying units are included in the reference law baseline. Thus, corporate tax rates below the maximum statutory rate do not give rise to a tax expenditure. The normal tax baseline is similar, except that it specifies the current maximum rate as the baseline for the corporate income tax. The lower tax rates applied to the first $10 million of corporate income are thus regarded as a tax expenditure. Similarly, under the reference law baseline, preferential tax rates for capital gains generally do not yield a tax expenditure; only capital gains treatment of otherwise ‘‘ordinary income,’’ such as that from coal and iron ore royalties and the sale of timber and certain agricultural products, is considered a tax expenditure. The alternative minimum tax is treated as part of the baseline rate structure under both the reference and normal tax methods. • Income subject to the tax. Income subject to tax is defined as gross income less the costs of earning that income. The Federal income tax defines gross income to include: (1) consideration received in the exchange of goods and services, including labor ANALYTICAL PERSPECTIVES services or property; and (2) the taxpayer’s share of gross or net income earned and/or reported by another entity (such as a partnership). Under the reference tax rules, therefore, gross income does not include gifts—defined as receipts of money or property that are not consideration in an exchange—or most transfer payments, which can be thought of as gifts from the Government.2 The normal tax baseline also excludes gifts between individuals from gross income. Under the normal tax baseline, however, all cash transfer payments from the Government to private individuals are counted in gross income, and exemptions of such transfers from tax are identified as tax expenditures. The costs of earning income are generally deductible in determining taxable income under both the reference and normal tax baselines.3 • Capital recovery. Under the reference tax law baseline no tax expenditures arise from accelerated depreciation. Under the normal tax baseline, the depreciation allowance for machinery and equipment is determined using straight-line depreciation over tax lives equal to mid-values of the asset depreciation range (a depreciation system in effect from 1971 through 1980). The normal tax baseline for real property is computed using 40-year straight-line depreciation. • Treatment of foreign income. Both the normal and reference tax baselines allow a tax credit for foreign income taxes paid (up to the amount of U.S. income taxes that would otherwise be due), which prevents double taxation of income earned abroad. Under the normal tax method, however, controlled foreign corporations (CFCs) are not regarded as entities separate from their controlling U.S. shareholders. Thus, the deferral of tax on income received by CFCs is regarded as a tax expenditure under this method. In contrast, except for tax haven activities, the reference law baseline follows current law in treating CFCs as separate taxable entities whose income is not subject to U.S. tax until distributed to U.S. taxpayers. Under this baseline, deferral of tax on CFC income is not a tax expenditure because U.S. taxpayers generally are not taxed on accrued, but unrealized, income. In addition to these areas of difference, the Joint Committee on Taxation considers a somewhat broader set of tax expenditures under its normal tax baseline than is considered here. 2 Gross income does, however, include transfer payments associated with past employment, such as social security benefits. 3 In the case of individuals who hold ‘‘passive’’ equity interests in businesses, however, the pro-rata shares of sales and expense deductions reportable in a year are limited. A passive business activity is defined to be one in which the holder of the interest, usually a partnership interest, does not actively perform managerial or other participatory functions. The taxpayer may generally report no larger deductions for a year than will reduce taxable income from such activities to zero. Deductions in excess of the limitation may be taken in subsequent years, or when the interest is liquidated. 5. TAX EXPENDITURES Performance Measures and the Economic Effects of Tax Expenditures Under the Government Performance and Results Act of 1993 (GPRA), Federal agencies are directed to develop both strategic and annual plans for their programs and activities. These plans set out performance objectives to be achieved over a specific time period. Achieving most of these objectives will largely be the result of direct expenditures of funds. However, tax expenditures may also contribute to goal achievement. The Senate Governmental Affairs Committee report on this Act4 called on the Executive branch to undertake a series of analyses to assess the effect of specific tax expenditures on the achievement of the goals and objectives in these strategic and annual plans. As described in OMB’s May 1997 report on this Act,5 Treasury in 1997 initiated pilot studies of three specific tax expenditures in order to explore evaluation methods and resource needs associated with evaluating the relationship between tax expenditures and performance goals. Tax expenditures were selected within the Office of Tax Analysis in each of the three main areas—individual, business, and international taxation. The specific provisions considered were: the tax exemption for worker’s compensation benefits; the tax credit for nonconventional fuels; and the tax exclusion for certain amounts of income earned by Americans living abroad. The results of these studies are summarized in the context of the three specific provisions in the section that follows, which provides provision descriptions. Over the next few years, the Administration’s plan is to undertake additional studies that will focus on the availability of the data needed to assess the effects of selected significant tax expenditures, primarily those designed to increase savings. In addition, summarized data on the beneficiaries and other economic properties of such provisions will be developed where feasible. This effort will complement information published by the Joint Committee on Taxation and the Senate Budget Committee on the rationale, beneficiaries, and effects of tax expenditures.6 One finding of the pilot studies is that much of the data needed for thorough analysis is not currently available. Hence, assessment of data needs and availability from Federal statistical agencies, program-agency studies, or private-sector sources, and, when feasible, publication of data on selected tax expenditures should prove valuable to broader efforts to assess the effects tax expenditures and to compare their effectiveness with outlay, regulatory and other tax polices as means of achieving objectives. Comparisons of tax expenditure, spending, and regulatory policies. Tax expenditures by definition work through the tax system and, particularly, the in4 Committee on Government Affairs, United States Senate, ‘‘Government Performance and Results Act of 1993’’ (Report 103–58, 1993). 5 Director of the Office of Management and Budget, ‘‘The Government Performance and Results Act,’’ Report to the President and the Congress, May 1997. 6 Joint Committee on Taxation, ‘‘Estimates of Federal Tax Expenditures for Fiscal Years 1999–1993,’’ JCS-7–98, December 14, 1998; and Committee on the Budget, United States Senate, ‘‘Tax Expenditures: Compendium of Background Material on Individual Provisions,’’ prepared by the Congressional Research Service (S. Prt. 104–69, December 1996). 121 come tax. Thus, they may be relatively advantageous policy approaches when the benefit or incentive is related to income and is intended to be widely available.7 Because there is an existing public administrative and private compliance structure for the tax system, the incremental administrative and compliance costs for a tax expenditure may be low in many, though not all, cases. In addition, tax expenditures may help simplify the tax system, as where they leave certain income sources untaxed (e.g, exemptions for employer fringe benefits or exclusions for up to $500,000 of capital gains on home sales). Tax expenditures also implicitly subsidize certain activities, which benefit recipients; the beneficiaries experience reduced taxes that are offset by higher taxes (or spending reductions) elsewhere. Regulatory or tax-disincentive policies, which can also modify behavior, would have a different distributional impact. Finally, a variety of tax expenditure tools can be used—e.g., deductions, credits, exemptions and deferrals; floors and ceilings; and phase-ins and phaseouts, dependent on income, expenses, or demographic characteristics (age, number of family members, etc.). This wide range means that tax expenditures can be flexible and can have very different distributional and cost-effectiveness properties. Tax expenditures also have limitations. In some cases they can add to the complexity of the tax system, which can raise both administrative and compliance costs; for example, various holding periods and tax rates for capital gains can complicate filing and decisionmaking. Also, the income tax system does not gather information on wealth, in contrast to certain loan programs that are based on recipients’ assets and income. In addition, the tax system may have little or no contact with persons who have no or very low incomes, and incentives for such persons may need to take the form of refunds. These features may reduce the effectiveness of tax expenditures for addressing certain income-transfer objectives. Tax expenditures also generally do not enable the same degree of agency discretion as an outlay program; for example, grant or direct Federal service delivery programs can prioritize which activities are addressed with what amount of resources in a way that is difficult to emulate with tax expenditures. Finally, tax expenditures tend to escape the budget scrutiny afforded to other programs. For instance, a program funded by a tax expenditure does not increase government outlays as a share of national product and it may even decrease receipts as a share of output. However, the effective government compensation to a service provider can be identical to that of a spending program under which the outlay (and possibly the receipts) share of GDP may increase. Outlay programs, in contrast, have advantages where direct government service provision is particularly warranted—such as equipping and providing the armed forces or administering the system of justice. Outlay 7 While this section focuses upon tax expenditures under the income tax, tax preferences also arise under the unified transfer, payroll, and excise tax systems. Such preferences can be useful when they relate to the base of those taxes, such as an excise tax exemption for certain types of consumption deemed meritorious. 122 programs may also be specifically designed to meet the needs of low-income families who would not otherwise be subject to income taxes or need to file a return. Outlay programs may also receive more year-to-year oversight and fine tuning, through the legislative and executive budget process. In addition, many different types of spending programs—including direct government provision; credit programs; and payments to State and local governments, the private sector, or individuals in the form of grants or contracts—provide flexibility for policy design. On the other hand, certain outlay programs—such as direct government service provision—may rely less directly on economic incentives and private-market provision than tax incentives, which may reduce the relative efficiency of spending programs for some goals. Spending programs also require resources to be raised via taxes, user charges, or government borrowing. Finally, spending programs, particularly on the discretionary side, may respond less readily to changing activity levels and economic conditions than tax expenditures. Regulations have a key distributional difference from outlay and tax-expenditure programs in that the immediate distributional burden of the regulation typically falls on the regulated party (i.e., the intended actor)— generally in the private sector. While the regulated parties can pass costs along through product or input prices, the initial incidence is on the regulated party. Regulations can be fine-tuned more quickly than tax expenditures, as they can generally be changed by the executive branch without legislation. Like tax expenditures, regulations often largely rely upon voluntary compliance, rather than detailed inspections and policing. As such, the public administrative costs tend to be modest, relative to the private resource costs associated with modifying activities. Historically, regulations have tended to rely on proscriptive measures, as opposed to economic incentives. This reliance can diminish their economic efficiency, though this feature can also promote full compliance where (as in certain safety-related cases) policymakers believe that trade-offs with economic considerations are not of paramount importance. Also, regulations generally do not directly affect the Federal budget and outlays and receipts as a percentage of national output. Thus, like tax expenditures, they may escape the type of scrutiny that outlay programs receive. However, most regulations are subjected to a formal type of benefit-cost analysis that goes well beyond the analysis required for outlay and taxexpenditure programs. To some extent, the GPRA requirement for performance evaluation will address this lack of formal analysis. There are examples of policy objectives that employ multiple approaches. Minimum wage legislation, the earned income tax credit, and the food stamp program are examples of programs that utilize regulatory, tax expenditure, and direct outlay approaches, respectively, in order to improve the economic welfare of low-wage workers. Their relative strengths and weaknesses have merited significant attention. ANALYTICAL PERSPECTIVES Tax expenditures, like spending and regulatory programs, have a variety of objectives and effects. These include: encouraging certain types of activities (e.g., saving for retirement or investing in certain sectors); increasing certain types of after-tax income (e.g., favorable tax treatment of social security income); reducing private compliance costs and government administrative costs (e.g., favorable treatment of certain employerprovided fringe benefits); and promoting tax neutrality (e.g., accelerated depreciation in the presence of inflation). Some of these objectives are well suited to quantitative measurement, while others are less well suited. Also, many tax expenditures, including those cited above, may have more than one objective. For example, favorable treatment of employer-provided pensions might be argued to have aspects of most, or even all, of the goals mentioned above. In addition, the economic effects of particular provisions can extend beyond their intended objectives (e.g., a provision intended to promote an activity or raise certain incomes may have positive or negative effects on tax neutrality). Performance measurement is generally concerned with inputs, outputs, and outcomes. In the case of tax expenditures, the principal input is usually the tax revenue loss. Outputs are quantitative or qualitative measures of goods and services, or changes in income and investment, directly produced by these inputs. Outcomes, in turn, represent the changes in the economy, society, or environment that are the ultimate goals of programs. Thus, for a provision that reduces taxes on certain investment activity, an increase in the amount of investment would likely be a key output. The resulting production from that investment, and, in turn, the associated improvements in national income, welfare, or security, could be the outcomes of interest. For other provisions, such as those designed to address a potential inequity or unintended consequence in the tax code, an important performance measure might be how they change effective tax rates (the discounted present-value of taxes owed on new investments or incremental earnings) or excess burden (an economic measure of the distortions caused by taxes). Distributional effects on incomes may be an important measure for certain provisions. An overview of evaluation issues by budget function. The discussion below considers the types of measures that might be useful for some major programmatic groups of tax expenditures. The discussion is intended to be illustrative and not all encompassing. However, it is premised on the assumption that the data needed to perform the analysis are available or can be developed. In practice, data availability is likely to be a major challenge, and data constraints may limit the assessment of the effectiveness of many of the provisions for some time. In addition, such assessments can raise significant challenges in economic modeling. For these reasons, and related time, staffing, and resource constraints, the evaluation process is likely to take a number of years and to include qualitative assessments 5. TAX EXPENDITURES and estimated ranges of effects, in many cases, as opposed to point estimates. National defense.—Some tax expenditures are intended to assist governmental activities. For example, tax preferences for military benefits reflect, among other things, the view that benefits such as housing, subsistence, and moving expenses are intrinsic aspects of military service, and are provided, in part, for the benefit of the employer, the U.S. Government. Tax benefits for combat service are intended to reduce tax burdens on military personnel undertaking hazardous service for the Nation. A portion of the tax expenditure associated with foreign earnings is targeted to benefit U.S. Government civilian personnel working abroad by offsetting the living costs that can be higher than those in the United States. These tax expenditures should be considered together with direct agency budget costs in making programmatic decisions. International affairs.—Tax expenditures are also aimed at promoting U.S. exports. These include the exclusion for income earned abroad by nongovernmental employees and preferences for income from exports and U.S.-controlled foreign corporations. Measuring the effectiveness of these provisions raises challenging issues. In addition to determining their effectiveness in markets of the benefitting firms, analysis should consider the extent to which macroeconomic factors lead to offsetting effects, such as increased imports, which could moderate any net effects on employment, national output, and trade deficits. Similar issues arise in the case of export promotion programs supported by outlays. General science, space and technology; energy; natural resources and the environment; agriculture; and commerce and housing.—A series of tax expenditures reduces the cost of investment, both in specific activities—such as research and experimentation, extractive industries, and certain financial activities—and more generally, through accelerated depreciation for plant and equipment. These provisions can be evaluated along a number of dimensions. For example, it could be useful to consider the strength of the incentives by measuring their effects on the cost of capital (the interest rate which investments must yield to cover their costs) and effective tax rates. The impact of these provisions on the amounts of corresponding forms of investment—such as research spending, exploration activity, or equipment—could also be estimated. In some cases, such as research, there is evidence that the investment can provide significant positive externalities—that is, economic benefits that are not reflected in the market transactions between private parties. It could be useful to quantify these externalities and compare them with the degree of tax subsidy provided. Measures could also indicate the provisions’ effects on production from these investments—such as numbers or values of patents, energy production and reserves, and industrial production. Issues to be considered include the extent to which the preferences in- 123 crease production (as opposed to benefitting existing output) and their cost-effectiveness relative to other policies. Analysis could also consider objectives that are more difficult to measure but still are ultimate goals, such as promoting the Nation’s technological base, energy security, environmental quality, or economic growth. Such an assessment is likely to involve tax analysis as well as consideration of non-tax matters such as market structure, scientific, and other information (such as the effects of increased domestic fuel production on imports from various regions, or the effects of various energy sources on the environment). Housing investment also benefits from tax expenditures, including the mortgage interest deduction and preferential treatment of capital gains on homes. Measures of the effectiveness of these provisions could include their effects on increasing the extent of home ownership and the quality of housing. In addition, the mortgage interest deduction offsets the taxable nature of investment income received by homeowners, so the relationship between the deduction and such earnings is also relevant to evaluation of this provision. Similarly, analysis of the extent of accumulated inflationary gains is likely to be relevant to evaluation of the capital gains preference for home sales. Deductibility of State and local property taxes assists with making housing more affordable as well as easing the cost of providing community services through these taxes. Provisions intended to promote investment in rental housing could be evaluated for their effects on making such housing more available and affordable. These provisions should then be compared with alternative programs that address housing supply and demand. Transportation.—Employer-provided parking is a fringe benefit that, for the most part, is excluded from taxation. The tax expenditure revenue loss estimates reflect the cost of parking that is leased by employers for employees; an estimate is not currently available for the value of parking owned by employers and provided to their employees. The exclusion for employerprovided transit passes is intended to promote use of this mode of transportation, which has environmental and congestion benefits. The tax treatments of these different benefits could be compared with alternative transportation policies. Community and regional development.—A series of tax expenditures is intended to promote community and regional development by reducing the costs of financing specialized infrastructure, such as airports, docks, and stadiums. Empowerment zone and enterprise community provisions are designed to promote activity in disadvantaged areas. These provisions can be compared with grant and other policies designed to spur economic development. Education, training, employment, and social services.—Major provisions in this function are intended to promote post-secondary education, to offset costs of raising children, and to promote a variety of 124 charitable activities. The education incentives can be compared with loans, grants, and other programs designed to promote higher education and training. The child credits are intended to adjust the tax system for the costs of raising children; as such, they could be compared to other Federal tax and spending policies, including related features of the tax system, such as personal exemptions (which are not defined as a tax expenditure). Evaluation of charitable activities requires consideration of the beneficiaries of these activities, who are generally not the parties receiving the tax reduction. Health.—Individuals also benefit from favorable treatment of employer-provided health insurance. Measures of these benefits could include increased coverage and the distribution of this coverage across different income groups. The effects of insurance coverage on final outcome measures of actual health (e.g., infant mortality, days of work lost due to illness, or life expectancy) or intermediate outcomes (e.g., use of preventive health care or health care costs) could also be investigated. The distribution of employer-provided health insurance is not readily evident from tax return information; thus, the distribution of benefits from this exclusion must be imputed using tax as well as other forms of information. Income security, social security, and veterans benefits and services.—Major tax expenditures in the income security function benefit retirement savings, through employer-provided pensions, individual retirement accounts, and Keogh plans. These provisions might be evaluated in terms of their effects on boosting retirement incomes, private savings, and national savings (which would include the effect on private savings as well as public savings or deficits). In considering the provisions’ distributional effects, it may be useful to consider beneficiaries’ incomes while retired and over their entire lifetimes. Interactions with other programs, including social security, also may merit analysis. As in the case of employer-provided health insurance, analysis of employer-provided pension programs requires imputing the benefits of the firm-level contributions back to individuals. Other provisions principally have income distribution, rather than incentive, effects. For example, tax-favored treatment of social security benefits, certain veterans benefits, and deductions for the blind and elderly provide increased incomes to eligible parties. The distribution of these benefits may be a useful performance measure. The earned-income tax credit, in contrast, should be evaluated both for its effects on labor force participation and its distributional properties. General purpose fiscal assistance and interest.— The tax-exemption for public purpose State and local bonds reduces the costs of borrowing for a variety of purposes; borrowing for non-public purposes is reflected under other budget functions. The deductibility of certain State and local taxes reflected under this function ANALYTICAL PERSPECTIVES primarily relates to personal income taxes; property tax deductibility is reflected under the commerce and housing function. Tax preferences for Puerto Rico and other U.S. possessions are also included here. These provisions can be compared with other tax and spending policies as means of benefitting fiscal and economic conditions in the States, localities, and possessions. Finally, the tax deferral for interest on U.S. savings bonds benefits savers who invest in these instruments; the extent of these benefits and any effects on Federal borrowing costs could be evaluated. The above illustrative discussion, while broad, is nevertheless incomplete, both for the provisions mentioned and the many that are not explicitly cited. Developing a framework that is sufficiently comprehensive, accurate, and flexible to reflect the objectives and effects of the wide range of tax expenditures will be a significant challenge. OMB, Treasury, and other agencies will work together, as appropriate, to address this challenge. Particularly over the next few years, a significant portion of this effort is likely to be devoted to data issues. Because the compilation of data is resource intensive, and must be balanced with other objectives (including minimizing information collection burdens), careful planning will be essential. Given the challenges inherent in this work, the nature of the analyses is likely to evolve and improve over the next several years. Other Considerations The tax expenditure analysis could be extended beyond the income and transfer taxes to include payroll and excise taxes. The exclusion of certain forms of compensation from the wage base, for instance, reduces payroll taxes, as well as income taxes. Payroll tax exclusions are complex to analyze, however, because they also affect social insurance benefits. Certain targeted excise tax provisions might also be considered tax expenditures. In this case challenges include determining an appropriate baseline. Descriptions of Income Tax Provisions Descriptions of the individual and corporate income tax expenditures reported upon in this chapter follow. National Defense 1. Benefits and allowances to armed forces personnel.—The housing and meals provided military personnel, either in cash or in kind, as well as certain amounts of pay related to combat service, are excluded from income subject to tax. International Affairs 2. Income earned abroad.—In 1998, a U.S. citizen or resident alien who resides or stays overseas for at least 11 of the past 12 months may exclude $72,000 per year of foreign-earned income. The exclusion limit increases in $2,000 annual increments until it reaches $80,000 in 2002. Eligible taxpayers also may exclude or deduct reasonable housing costs in excess of onesixth of the salary of a civil servant at grade GS-14, 125 5. TAX EXPENDITURES step 1 ($61,656 in 1998). Federal employees working abroad are not eligible for the foreign-earned income exclusion. Federal employees, however, may exclude certain allowances from their taxable income. The exclusion for certain income earned abroad was one of the tax expenditures examined by the Department of the Treasury in its pilot performance evaluations this year. This tax expenditure consists of two specific components: section 911 of the tax code, which covers private-sector employees, and section 912, which covers civilian government employees.8 The benefits for private-sector employees account for about 85 percent of the combined revenue loss from the two tax expenditures. The private-sector provision is intended to promote U.S. exports, help make U.S. companies competitive when doing business abroad, and to offset the costs of living abroad, which can be higher than costs in the United States. Because American workers in higher-tax nations can offset their U.S. taxes through use of the foreign tax credit, in practice the provision primarily benefits U.S. citizens who work in nations with income taxes that are lower than U.S. taxes. Using tax-return data from 1987, Treasury finds that 70 percent of the benefit of the provision goes to taxpayers with income (defined here as adjusted gross income plus the exclusion) above $50,000; over 98 percent of the housing exclusion, went to this group of taxpayers. The provision benefitting civilian government employees is intended to help them maintain their standard of living when stationed abroad by compensating them for the higher costs of living abroad. To the extent that this compensation is carried out via the tax code, as opposed to agency appropriations, costs are shifted from outlays to revenue losses. 3. Income of Foreign Sales Corporations.—The Foreign Sales Corporation (FSC) provisions exempt from tax a portion of U.S. exporters’ foreign trading income to reflect the FSC’s sales functions as foreign corporations. These provisions conform to the General Agreement on Tariffs and Trade. 4. Sales source rule exceptions.—The worldwide income of U.S. persons is taxable by the United States and a credit for foreign taxes paid is allowed. The amount of foreign taxes that can be credited is limited to the pre-credit U.S. tax on the foreign source income. The sales source rules for inventory property allow U.S. exporters to use more foreign tax credits by allowing the exporters to attribute a larger portion of their earnings abroad than would be the case if the allocation of earnings was based on actual economic activity. 5. Income of U.S.-controlled foreign corporations.—The income of foreign corporations controlled by U.S. shareholders is not subject to U.S. taxation. The income becomes taxable only when the controlling U.S. shareholders receive dividends or other distributions from their foreign stockholding. Under the normal tax method, the currently attributable foreign source 8 Section 911 was also the subject of a January 1993 Treasury report to Congress, ‘‘Taxation of Americans Working Overseas.’’ pre-tax income from such a controlling interest is subject to U.S. taxation, whether or not distributed. Thus, the normal tax method considers the amount of controlled foreign corporation income not distributed to a U.S. shareholder as tax-deferred income. 6. Exceptions under subpart F for active financing income.—Financial firms can defer taxes on income earned overseas in an active business. This provision was originally enacted in the Taxpayer Relief Act of 1997, was canceled by a line-item veto by the President, and was restored by the Supreme Court decision declaring the line-item veto unconstitutional. General Science, Space, and Technology 7. Expensing R&E expenditures.—Research and experimentation (R&E) projects can be viewed as investments because, if successful, their benefits accrue for several years. It is often difficult, however, to identify whether a specific R&E project is successful and, if successful, what its expected life will be. Under the normal tax method, the expensing of R&E expenditures is viewed as a tax expenditure. The baseline assumed for the normal tax method is that all R&E expenditures are successful and have an expected life of five years. 8. R&E credit.—The research and experimentation (R&E) credit, which expired on June 30, 1998, was reinstated (retroactively) in the Tax and Trade Relief Extension Act of 1998 for one year (through June 30, 1999). The tax credit is 20 percent of qualified research expenditures in excess of a base amount. The base amount is generally determined by multiplying a ‘‘fixedbase percentage’’ (limited to a maximum of .16) by the average amount of the company’s gross receipts for the 1984 to 1988 period. Certain start-up companies are assigned a fixed-base percentage of .03 for the first five taxable years, which is gradually phased out in years 6 through 10 and replaced by the firm’s actual fixed-base percentage. Taxpayers may also elect an alternative credit regime. Under the alternative credit regime, the credit rate is reduced and the taxpayer is assigned a three-tiered fixed-base percentage that is lower than the fixed-base percentage that would otherwise apply. A credit with a separate threshold is provided for a taxpayer’s payments to universities for basic research. Energy 9. Exploration and development costs.—For successful investments in domestic oil and gas wells, intangible drilling costs (e.g., wages, the costs of using machinery for grading and drilling, the cost of unsalvageable materials used in constructing wells) may be expensed rather than amortized over the productive life of the property. Integrated oil companies may deduct only 70 percent of such costs and must amortize the remaining 30 percent over five years. The same rule applies to the exploration and development costs of surface stripping and the construction of shafts and tunnels for other fuel minerals. 126 10. Percentage depletion.—Independent fuel mineral producers and royalty owners are generally allowed to take percentage depletion deductions rather than cost depletion on limited quantities of output. Under cost depletion, outlays are deducted over the productive life of the property based on the fraction of the resource extracted. Under percentage depletion, taxpayers deduct a percentage of gross income from mineral production at rates of 22 percent for uranium; 15 percent for oil, gas and oil shale; and 10 percent for coal. The deduction is limited to 50 percent of net income from the property, except for oil and gas where the deduction can be 100 percent of net property income. Production from geothermal deposits is eligible for percentage depletion at 65 percent of net income, but with no limit on output and no limitation with respect to qualified producers. Unlike depreciation or cost depletion, percentage depletion deductions can exceed the cost of the investment. 11. Alternative fuel production credit.—A nontaxable credit of $3 per barrel (in 1979 dollars) of oilequivalent production is provided for several forms of alternative fuels. The credit is generally available if the price of oil stays below $29.50 (in 1979 dollars). The credit generally expires on December 31, 2002. Treasury reviewed the nonconventional fuel production tax credit as one of its pilot studies of tax expenditures under the Government Performance and Results Act. The provision provides a significant credit—currently about $6 per barrel of oil equivalent or $1 per thousand cubic feet of natural gas, or roughly half of the wellhead price of gas. Coalbed methane (natural gas) and gas from tight formations currently account for most of the credit. While the credit has been effective in stimulating the coalbed methane industry, increased domestic production of natural gas tends to discourage imports from stable suppliers (in particular, Canada), so there is relatively little benefit to U.S. energy security. In addition, there are indications that credit-qualified gas displaced some non-qualified domestic gas. 12. Oil and gas exception to passive loss limitation.—Owners of working interests in oil and gas properties are exempt from the ‘‘passive income’’ limitations. As a result, the working interest-holder, who manages on behalf of himself and all other owners the development of wells and incurs all the costs of their operation, may aggregate negative taxable income from such interests with his income from all other sources. 13. Capital gains treatment of royalties on coal.—Sales of certain coal under royalty contracts can be treated as capital gains rather than ordinary income. 14. Energy facility bonds.—Interest earned on state and local bonds used to finance construction of certain energy facilities is tax-exempt. These bonds are generally subject to the state private-activity bond annual volume cap. 15. Enhanced oil recovery credit.—A credit is provided equal to 15 percent of the taxpayer’s costs for tertiary oil recovery on U.S. projects. Qualifying costs ANALYTICAL PERSPECTIVES include tertiary injectant expenses, intangible drilling and development costs on a qualified enhanced oil recovery project, and amounts incurred for tangible depreciable property. 16. New technology credits.—A credit of 10 percent is available for investment in solar and geothermal energy facilities. In addition, a credit of 1.5 cents is provided per kilowatt hour of electricity produced from renewable resources such as wind and biomass. The renewable resources credit applies only to electricity produced by a facility placed in service before July 1, 1999. 17. Alcohol fuel credits.—An income tax credit is provided for ethanol that is derived from renewable sources and used as fuel. The credit equals 54 cents per gallon in 1998, 1999, and 2000. The Transportation Equity Act of the 21st Century made the credit 53 cents per gallon in 2001 and 2002; 52 cents per gallon in 2003 and 2004; and 51 cents per gallon in 2005, 2006, and 2007. To the extent that ethanol is mixed with taxable motor fuel to create gasohol, taxpayers may claim an exemption of the federal excise tax rather than the income tax credit. In addition, small ethanol producers are eligible for a separate 10 cents per gallon credit. 18. Credit and deduction for clean-fuel vehicles and property.—A tax credit of 10 percent (not to exceed $4,000) is provided for purchasers of electric vehicles. Purchasers of other clean-fuel burning vehicles and owners of clean-fuel refueling property may deduct part of their expenditures. The credit and deduction are phased out from 2002 through 2005. 19. Exclusion of utility conservation subsidies.— Subsidies by public utilities for non-business customer expenditures on energy conservation measures are excluded from the gross income of the customer. Natural Resources and Environment 20. Exploration and development costs.—Certain capital outlays associated with exploration and development of nonfuel minerals may be expensed rather than depreciated over the life of the asset. 21. Percentage depletion.—Most nonfuel mineral extractors may use percentage depletion rather than cost depletion, with percentage depletion rates ranging from 22 percent for sulphur to 5 percent for sand and gravel. 22. Sewage, water, and hazardous waste bonds.—Interest earned on state and local bonds used to finance the construction of sewage, water, or hazardous waste facilities is tax-exempt. These bonds are generally subject to the state private-activity bond annual volume cap. 23. Capital gains treatment of certain timber.— Certain timber sold under a royalty contract can be treated as capital gains rather than ordinary income. 24. Expensing multiperiod timber growing costs.—Most of the production costs of growing timber may be expensed rather than capitalized and deducted when the timber is sold. In most other industries, these 127 5. TAX EXPENDITURES costs are capitalized under the uniform capitalization rules. 25. Credit and seven-year amortization for reforestation.—A 10-percent investment tax credit is allowed for up to $10,000 invested annually to clear land and plant trees for the production of timber. Up to $10,000 in forestation investment may also be amortized over a seven-year period rather than capitalized and deducted when the trees are sold or harvested. The amount of forestation investment that is amortizable is not reduced by any of the allowable investment credit. 26. Historic preservation.—Expenditures to preserve and restore historic structures qualify for a 20percent investment credit, but the depreciable basis must be reduced by the full amount of the credit taken. Agriculture 27. Expensing certain capital outlays.—Farmers, except for certain agricultural corporations and partnerships, are allowed to expense certain expenditures for feed and fertilizer, as well as for soil and water conservation measures. Expensing is allowed, even though these expenditures are for inventories held beyond the end of the year, or for capital improvements that would otherwise be capitalized. 28. Expensing multiperiod livestock and crop production costs.—The production of livestock and crops with a production period of less than two years is exempt from the uniform cost capitalization rules. Farmers establishing orchards, constructing farm facilities for their own use, or producing any goods for sale with a production period of two years or more may elect not to capitalize costs. If they do, they must apply straight-line depreciation to all depreciable property they use in farming. 29. Loans forgiven solvent farmers.—Farmers are forgiven the tax liability on certain forgiven debt. Normally, the debtor must include the amount of loan forgiveness as income or reduce his recoverable basis in the property to which the loan relates. If the debtor elects to reduce basis and the amount of forgiveness exceeds his basis in the property, the excess forgiveness is taxable. For insolvent (bankrupt) debtors, however, the amount of loan forgiveness never results in an income tax liability.9 Farmers with forgiven debt are considered insolvent for tax purposes, and thus qualify for income tax forgiveness. 30. Capital gains treatment of certain income.— Certain agricultural income, such as unharvested crops, can be treated as capital gains rather than ordinary income. 31. Income averaging for farmers.—The Tax and Trade Relief Extension Act of 1998 permanently extended the provision that allows taxpayers to lower their tax liability by averaging, over the prior threeyear period, their taxable income from farming. Without 9 The insolvent taxpayer’s carryover losses and unused credits are extinguished first, and then his basis in assets reduced to no less than amounts still owed creditors. Finally, the remainder of the forgiven debt is excluded from tax. extension, the provision generally would have expired on December 31, 2000. 32. Deferral of gain on sales of farm refiners.— A taxpayer who sells stock in a farm refiner to a farmers’ cooperative can defer recognition of gain if the taxpayer reinvests the proceeds in qualified replacement property. This provision was originally enacted in the Taxpayer Relief Act of 1997, was canceled by a lineitem veto by the President, and was restored by the Supreme Court decision declaring the line-item veto unconstitutional. Commerce and Housing This category includes a number of tax expenditure provisions that also affect economic activity in other functional categories. For example, provisions related to investment, such as accelerated depreciation, could be classified under the energy, natural resources and environment, agriculture, or transportation categories. 33. Credit union income.—The earnings of credit unions not distributed to members as interest or dividends are exempt from income tax. 34. Bad debt reserves.—Small (less than $500 million in assets) commercial banks, mutual savings banks, and savings and loan associations may deduct additions to bad debt reserves in excess of actually experienced losses. 35. Deferral of income on life insurance and annuity contracts.—Favorable tax treatment is provided for investment income within qualified life insurance and annuity contracts. Investment income earned on qualified life insurance contracts held until death is permanently exempt from income tax. Investment income distributed prior to the death of the insured is tax-deferred, if not tax-exempt. Investment income earned on annuities is treated less favorably than income earned on life insurance contracts, but it benefits from tax deferral without annual contribution or income limits generally applicable to other tax-favored retirement income plans. 36. Small property and casualty insurance companies.— Insurance companies that have annual net premium incomes of less than $350,000 are exempt from tax; those with $350,000 to $2,100,000 of net premium incomes may elect to pay tax only on the income earned by their investment portfolio. 37. Insurance companies owned by exempt organizations.—Generally, the income generated by life and property and casualty insurance companies is subject to tax, albeit by special rules. Insurance operations conducted by such exempt organizations as fraternal societies and voluntary employee benefit associations, however, are exempt from tax. 38. Small life insurance company deduction.—Small life insurance companies (gross assets of less than $500 million) can deduct 60 percent of the first $3 million of otherwise taxable income. The deduction phases out for otherwise taxable income between $3 million and $15 million. 128 39. Mortgage housing bonds.—Interest earned on state and local bonds used to finance homes purchased by first-time, low-to-moderate-income buyers is tax-exempt. The amount of state and local tax-exempt bonds that can be issued to finance such private activity is limited. The combined volume cap for mortgage housing bonds, rental housing bonds, student loan bonds, and industrial development bonds is $50 per capita ($150 million minimum) per state. The Tax and Trade Relief Extension Act of 1998 increased the volume cap to $55 per capita ($165 million minimum) in 2003 and ratably annually thereafter until the cap reaches $75 per capita ($225 million minimum) in 2007. States may issue mortgage credit certificates (MCCs) in lieu of mortgage revenue bonds. MCCs entitle home buyers to income tax credits for a specified percentage of interest on qualified mortgages. The total amount of MCCs issued by a state cannot exceed 25 percent of its annual ceiling for mortgage-revenue bonds. 40. Rental housing bonds.—Interest earned on state and local government bonds used to finance multifamily rental housing projects is tax-exempt. At least 20 percent (15 percent in targeted areas) of the units must be reserved for families whose income does not exceed 50 percent of the area’s median income; or 40 percent for families with incomes of no more than 60 percent of the area median income. Other tax-exempt bonds for multifamily rental projects are generally issued with the requirement that all tenants must be low or moderate income families. Rental housing bonds are subject to the volume cap discussed in the mortgage housing bond section above. 41. Interest on owner-occupied homes.—Owner-occupants of homes may deduct mortgage interest on their primary and secondary residences as itemized nonbusiness deductions. The mortgage interest deduction is limited to interest on debt no greater than the owner’s basis in the residence and, for debt incurred after October 13, 1987, it is limited to no more than $1 million. Interest on up to $100,000 of other debt secured by a lien on a principal or second residence is also deductible, irrespective of the purpose of borrowing, provided the debt does not exceed the fair market value of the residence. Mortgage interest deductions on personal residences are tax expenditures because the taxpayers are not required to report the value of owner-occupied housing services as gross income. 42. Taxes on owner-occupied homes.—Owner-occupants of homes may deduct property taxes on their primary and secondary residences even though they are not required to report the value of owner-occupied housing services as gross income. 43. Installment sales.—Dealers in real and personal property (i.e., sellers that regularly hold property for sale or resale) cannot defer taxable income from installment sales until the receipt of the loan repayment. Nondealers (i.e., sellers of real property used in their business) are required to pay interest on deferred taxes attributable to their total installment obligations in excess of $5 million. Only properties with sales prices ANALYTICAL PERSPECTIVES exceeding $150,000 are includable in the total. The payment of a market rate of interest eliminates the benefit of the tax deferral. The tax exemption for nondealers with total installment obligations of less than $5,000,000 is, therefore, a tax expenditure. 44. Capital gains exclusion on home sales.—A homeowner can exclude from tax up to $500,000 ($250,000 for singles) of the capital gains from the sale of a principal residence. The exclusion may not be used more than once every two years. 45. Passive loss real estate exemption.—In general, passive losses may not offset income from other sources. Losses up to $25,000 attributable to certain rental real estate activity, however, are exempt from this rule. 46. Low-income housing credit.—Taxpayers who invest in certain low-income housing are eligible for a tax credit. The credit rate is set so that the present value of the credit is equal to 70 percent for new construction and 30 percent for (1) housing receiving other Federal benefits (such as tax-exempt bond financing), or (2) substantially rehabilitated existing housing. The credit is allowed in equal amounts over 10 years. State agencies determine who receives the credit; states are limited in the amount of credit they may authorize annually to $1.25 per resident. 47. Accelerated depreciation of rental property.— The tax depreciation allowance provisions are part of the reference law rules, and thus do not cause tax expenditures under the reference method. Under the normal tax method, however, a 40-year tax life for depreciable real property is the norm. Thus, statutory depreciation period for rental property of 27.5 years is a tax expenditure. In addition, tax expenditures arise from pre-1987 tax allowances for rental property. 48. Cancellation of indebtedness.—Individuals are not required to report the cancellation of certain indebtedness as current income. If the canceled debt is not reported as current income, however, the basis of the underlying property must be reduced by the amount canceled. 49. Imputed interest rules.—Holders (issuers) of debt instruments are generally required to report interest earned (paid) in the period it accrues, not when paid. In addition, the amount of interest accrued is determined by the actual price paid, not by the stated principal and interest stipulated in the instrument.10 In general, any debt associated with the sale of property worth less than $250,000 is excepted from the general interest accounting rules. This general $250,000 exception is not a tax expenditure under reference law but is under normal law. Exceptions above $250,000 are a tax expenditure under reference law; these exceptions include the following: (1) sales of personal residences worth more than $250,000, and (2) sales of 10 For example, if a borrower on December 31, 1997 issues a promise to pay $1,000 plus interest at 10 percent on December 30, 1999, for a total repayment of $1,100 and accepts $900 from a lender in exchange for the contract, the rules require that both parties (a) recognize that $900 is the amount lent, so that the effective loan interest rate is not the stated 10 percent but is 22.2 percent, and (b) report $200 as interest paid or received in 1999. 5. TAX EXPENDITURES farms and small businesses worth between $250,000 and $1 million. 50. Capital gains (other than agriculture, timber, iron ore, and coal).—Capital gains on assets held for more than 1 year are taxed at a lower rate than ordinary income. The lower rate on capital gains is considered a tax expenditure under the normal tax method but not under the reference law method. For assets held for more than 1 year and sold after December 31, 1997, the top tax rate is 20 percent (10 percent for taxpayers who would otherwise pay capital gains tax at the 15-percent rate). The IRS Restructuring and Reform Act of 1998 eliminated the 28-percent capital gains rate by lowering the holding period for the 20-percent capital gains rate from 15 years to 1 year. In addition, for assets acquired after December 31, 2000, the maximum capital gains tax rates for assets held more than 5 years are 8 percent and 18 percent (rather than 10 percent and 20 percent). On January 1, 2001, taxpayers may mark-to-market existing assets to start the 5-year holding period. 51. Capital gains exclusion for small business stock.—An exclusion of 50 percent is provided for capital gains from qualified small business stock held by individuals for more than 5 years. A qualified small business is a corporation whose gross assets do not exceed $50 million as of the date of issuance of the stock. 52. Step-up in basis of capital gains at death.— Capital gains on assets held at the owner’s death are not subject to capital gains taxes. The cost basis of the appreciated assets is adjusted upward to the market value at the owner’s date of death. The step-up in the heir’s cost basis means that, in effect, the tax on the capital gain is forgiven. 53. Carryover basis of capital gains on gifts.— When a gift is made, the transferred property carries to the donee the donor’s basis—the cost that was incurred when the property was first acquired. The carryover of the donor’s basis allows a continued deferral of unrealized capital gains. 54. Ordinary income treatment of losses from sale of small business corporate stock shares.— Up to $100,000 in losses from the sale of small business corporate stock (capitalization less than $1 million) may be treated as ordinary losses. Such losses would, thus, not be subject to the $3,000 annual capital loss writeoff limit. 55. Accelerated depreciation of non-rental-housing buildings.—The tax depreciation allowance provisions are part of the reference law rules, and thus do not cause tax expenditures under reference law. Under normal law, however, a 40-year life for nonrental-housing buildings is the norm. Thus, the 39-year depreciation period for property placed in service after February 25, 1993, the 31.5-year depreciation period for property placed in service from 1987 to February 25, 1993, and the pre-1987 depreciation periods create a tax expenditure. 129 56. Accelerated depreciation of machinery and equipment.—The tax depreciation allowance provisions are part of the reference law rules, and thus do not cause tax expenditures under reference law. Statutory depreciation of machinery and equipment, however, is accelerated somewhat relative to the normal tax baseline, creating a tax expenditure. 57. Expensing of certain small investments.—In 1998, qualifying investments in tangible property up to $18,500 can be expensed rather than depreciated over time. (The expensing limit increases annually until 2003, when it reaches $25,000). To the extent that qualifying investment during the year exceeds $200,000, the amount eligible for expensing is decreased. In 1998, the amount expensed is completely phased out when qualifying investments exceed $218,500. 58. Business start-up costs.—When taxpayers enter into a new business, certain start-up expenses, such as the cost of legal services, are normally incurred. Taxpayers may elect to amortize these outlays over 60 months even though they are similar to other payments made for nondepreciable intangible assets that are not recoverable until the business is sold. The normal tax method treats this amortization as a tax expenditure; the reference tax method does not. 59. Graduated corporation income tax rate schedule.—The corporate income tax schedule is graduated, with rates of 15 percent on the first $50,000 of taxable income, 25 percent on the next $25,000, and 34 percent on the next $9.925 million. Compared with a flat 34-percent rate, the lower rates provide an $11,750 reduction in tax liability for corporations with taxable income of $10 million. This benefit is recaptured for corporations with taxable incomes exceeding $100,000 by a 5-percent additional tax on corporate incomes in excess of $100,000, but less than $335,000. The corporate tax rate is 35 percent on income over $10 million. Compared with a flat 35-percent tax rate, the 34-percent rate provides a $100,000 reduction in tax liability for corporations with taxable incomes of $10 million. This benefit is recaptured for corporations with taxable incomes exceeding $15 million by a 3percent additional tax on income over $15 million but less than $18.33 million. Because the corporate rate schedule is part of reference tax law, it is not considered a tax expenditure under the reference method. A flat corporation income tax rate is taken as the baseline under the normal tax method; therefore the lower rates is considered a tax expenditure under this concept. 60. Small issue industrial development bonds.— Interest earned on small issue industrial development bonds (IDBs) issued by state and local governments to finance manufacturing facilities is tax-exempt. Depreciable property financed with small issue IDBs must be depreciated, however, using the straight-line method. The annual volume of small issue IDBs is subject to the unified volume cap discussed in the mortgage housing bond section above. 130 ANALYTICAL PERSPECTIVES Transportation 61. Deferral of tax on U.S. shipping companies.— Certain companies that operate U.S. flag vessels can defer income taxes on that portion of their income used for shipping purposes, primarily construction, modernization and major repairs to ships, and repayment of loans to finance these investments. Once indefinite, the deferral has been limited to 25 years since January 1, 1987.62. Exclusion of reimbursed employee parking expenses.—Parking at or near an employer’s business premises that is paid for by the employer is excludable from the income of the employee. In 1998, the maximum amount of the parking exclusion is $175 (indexed, except in 1999) per month. The tax expenditure estimate does not include parking at facilities owned by the employer. 63. Exclusion of employer-provided transit passes.—Transit passes, tokens, and fare cards provided by an employer to defray an employee’s commuting costs are excludable from the employee’s income if the total value of the benefit does not exceed the transit limit. In 1998, the limit is $65 (indexed, except in 1999) per month. Community and Regional Development 64. Rehabilitation of structures.—A 10-percent investment tax credit is available for the rehabilitation of buildings that are used for business or productive activities and that were erected before 1936 for other than residential purposes. The taxpayer’s recoverable basis must be reduced by the amount of the credit. 65. Airport, dock, and similar facility bonds.— Interest earned on state and local bonds issued to finance high-speed rail facilities and government-owned airports, docks, wharves, and sport and convention facilities is tax-exempt. These bonds are not subject to a volume cap. 66. Exemption of income of mutuals and cooperatives.—The incomes of mutual and cooperative telephone and electric companies are exempt from tax if at least 85 percent of their revenues are derived from patron service charges. 67. Empowerment zones and enterprise communities.—Qualifying businesses in designated economically depressed areas can receive tax benefits such as an employer wage credit, increased expensing of investment in equipment, special tax-exempt financing, and accelerated depreciation. A tax credit for contributions to certain community development corporations can also be available. In addition, certain first-time buyers of a principal residence in the District of Columbia can receive a tax credit, and investors in certain D.C. property can receive a capital gains break. 68. Expensing of environmental remediation costs.— Taxpayers who clean up hazardous substances at a qualified site may expense the clean-up costs, rather than capitalize the costs, even though the expenses will generally increase the value of the property significantly or appreciably prolong the life of the property. he expensing only applies to clean-up costs incurred after August 5, 1997 and before January 1, 2001. Education, Training, Employment, and Social Services 69. Scholarship and fellowship income.—Scholarships and fellowships are excluded from taxable income to the extent they pay for tuition and course-related expenses of the grantee. Similarly, tuition reductions for employees of educational institutions and their families are not included in taxable income. From an economic point of view, scholarships and fellowships are either gifts not conditioned on the performance of services, or they are rebates of educational costs. Thus, under the reference law method, this exclusion is not a tax expenditure because this method does not include either gifts or price reductions in a taxpayer’s gross income. The exclusion, however, is considered a tax expenditure under the normal tax method, which includes gift-like transfers of government funds in gross income (many scholarships are derived directly or indirectly from government funding). 70. HOPE tax credit.— The non-refundable HOPE tax credit allows a credit for 100 percent of an eligible student’s first $1,000 of tuition and fees and 50 percent of the next $1,000 of tuition and fees. The credit only covers tuition and fees paid during the first two years of a student’s post-secondary education. The credit is phased out ratably for taxpayers with modified AGI between $80,000 and $100,000 ($40,000 and $50,000 for singles). 71. Lifetime Learning tax credit.—The non-refundable Lifetime Learning tax credit allows a credit for 20 percent of an eligible student’s tuition and fees. For tuition and fees paid between July 1, 1998 and December 31, 2002, the maximum credit per return is $1,000. For tuition and fees paid after December 31, 2002, the maximum credit per return is $2,000. The credit is phased out ratably for taxpayers with modified AGI between $80,000 and $100,000 ($40,000 and $50,000 for singles). The credit applies to both undergraduate and graduate students. 72. Education Individual Retirement Accounts.— Contributions to an education IRA are not tax-deductible. Investment income earned by education IRAs is not taxed when earned, and investment income from an education IRA is tax-exempt when withdrawn to pay for a student’s tuition and fees. The maximum contribution to an education IRA is $500 per year per beneficiary. The maximum contribution is phased down ratably for taxpayers with modified AGI between $150,000 and $160,000 ($95,000 and $110,000 for singles). Contributions may not be made to an education IRA in any year in which a contribution has been made to a state tuition plan for the same beneficiary. 73. Student-loan interest.—Taxpayers may claim an above-the-line deduction of up to $2,500 ($1,000 in 1998, $1,500 in 1999, and $2,000 in 2000) on interest paid on an education loan. Interest may only be deducted for the first five years in which interest pay- 5. TAX EXPENDITURES ments are required. The maximum deduction is phased down ratably for taxpayers with modified AGI between $60,000 and $75,000 ($40,000 and $55,000 for singles). Only interest paid and due after December 31, 1997 may be deducted. 74. State prepaid tuition plans.—Some states have adopted prepaid tuition plans and prepaid room and board plans, which allow persons to pay in advance for college expenses for designated beneficiaries. Taxes on the earnings from these plans are paid by the beneficiaries and are deferred until the tuition is actually paid. 75. Student-loan bonds.—Interest earned on state and local bonds issued to finance student loans is taxexempt. The volume of all such private activity bonds that each state may issue annually is limited. 76. Bonds for private nonprofit educational institutions.—Interest earned on state and local government bonds issued to finance the construction of facilities used by private nonprofit educational institutions is not taxed. The aggregate volume of all such private activity bonds that each state may issue during any calendar year is limited. 77. Credit for holders of zone academy bonds.— Financial institutions that own zone academy bonds receive a non-refundable tax credit rather than interest. The credit is included in gross income. Proceeds from zone academy bonds may only be use to improve impoverished schools. The total amount of zone academy bonds that may be issued is limited to $800 million; no bonds may be issued before January 1, 1998. 78. U.S. savings bonds for education.—Interest earned on U.S. savings bonds issued after December 31, 1989 is tax-exempt if the bonds are transferred to an educational institution to pay for educational expenses. The tax exemption is phased out for taxpayers with AGI between $78,350 and $108,350 ($52,250 and $67,250 for singles) in 1998. 79. Dependent students age 19 or older.—Taxpayers may claim personal exemptions for dependent children age 19 or over who (1) receive parental support payments of $1,000 or more per year, (2) are full-time students, and (3) do not claim a personal exemption on their own tax returns. 80. Child credit.—Taxpayers with children under age 17 can qualify for a $500 child credit beginning January 1, 1999 ($400 in 1998). The credit is phased out for taxpayers at the rate of $50 per $1,000 of modified AGI above $110,000 ($75,000 for singles). The child credit is refundable for taxpayers with three or more children. 81. Charitable contributions to educational institutions.—Taxpayers may deduct contributions to nonprofit educational institutions. Taxpayers who donate capital assets to educational institutions can deduct the assets’ current value without being taxed on any appreciation in value. An individual’s total charitable contribution generally may not exceed 50 percent of adjusted gross income; a corporation’s total charitable 131 contributions generally may not exceed 10 percent of pre-tax income. 82. Employer-provided educational assistance.— Employer-provided educational assistance is excluded from an employee’s gross income even though the employer’s costs for this assistance are a deductible business expense. This exclusion applies only to non-graduate courses beginning before July 1, 2000. 83. Work opportunity tax credit.—Employers can claim a tax credit for qualified wages paid to individuals who begin work after September 30, 1996 and before July 1, 1999 and who are certified as members of various targeted groups. The Tax and Trade Relief Extension Act of 1998 extended the expiration date from July 1, 1998 to July 1, 1999. For employees hired before October 1, 1997, the amount of the credit that can be claimed is 35 percent of the first $6,000 paid during the first year of employment. For employees hired after September 30, 1997, the credit is 25 percent for employment of less than 400 hours and 40 percent for employment of 400 hours or more. Employers must reduce their deduction for wages paid by the amount of the credit claimed. 84. Welfare-to-work tax credit.—An employer is eligible for a tax credit on the first $20,000 of eligible wages paid to qualified long-term family assistance recipients during the first two years of employment. The credit is 35 percent of the first $10,000 of wages in the first year of employment and 50 percent of the first $10,000 of wages in the second year of employment. The maximum credit is $8,500 per employee. The credit applies to wages paid to employees who are hired after December 31, 1997 and before July 1, 1999. The Tax and Trade Relief Extension Act of 1998 extended the expiration date from May 1, 1999 to July 1, 1999. 85. Employer-provided child care.—Employer-provided child care is excluded from an employee’s gross income even though the employer’s costs for the child care are a deductible business expense. 86. Adoption credit and exclusion.—Taxpayers can receive a nonrefundable tax credit for qualified adoption expenses. The maximum credit is $5,000 per child ($6,000 for special needs adoptions, except foreign adoptions). The credit is phased-out ratably for taxpayers with modified AGI between $75,000 and $115,000. Unused credits may be carried forward. In lieu of the tax credit, taxpayers may exclude qualified adoption expenses from income, subject to the same maximum amounts and phase-out as the credit. The non-special needs adoption assistance and foreign special needs assistance expire on December 31, 2001. 87. Employer-provided meals and lodging.—Employer-provided meals and lodging are excluded from an employee’s gross income even though the employer’s costs for these items are a deductible business expense. 88. Child and dependent care expenses.—Married couples with child and dependent care expenses may claim a tax credit when one spouse works full time and the other works at least part time or goes to school. The credit may also be claimed by divorced or separated 132 ANALYTICAL PERSPECTIVES parents who have custody of children, and by single parents. Expenditures up to a maximum $2,400 for one dependent and $4,800 for two or more dependents are eligible for the credit. The credit is equal to 30 percent of qualified expenditures for taxpayers with incomes of $10,000 or less. The credit is reduced to a minimum of 20 percent by one percentage point for each $2,000 of income between $10,000 and $28,000. 89. Disabled access expenditure credit.—Small businesses (less than $1 million in gross receipts or fewer than 31 full-time employees) can claim a 50-percent credit for expenditures in excess of $250 to remove access barriers for disabled persons. The credit is limited to $5,000. 90. Expensing costs of removing architectural barriers.—Taxpayers can expense (up to $15,000 annually) the cost of removing architectural barriers to the handicapped rather than depreciate the cost over the useful life of the asset. 91. Charitable contributions, other than education and health.—Taxpayers may deduct contributions to charitable, religious, and certain other nonprofit organizations. Taxpayers who donate capital assets to charitable organizations can deduct the assets’ current value without being taxed on any appreciation in value. An individual’s total charitable contribution generally may not exceed 50 percent of adjusted gross income; a corporation’s total charitable contributions generally may not exceed 10 percent of pre-tax income. 92. Foster care payments.—Foster parents provide a home and care for children who are wards of the State, under contract with the State. Compensation received for this service is excluded from the gross incomes of foster parents; the expenses they incur are nondeductible. 93. Parsonage allowances.—The value of a minister’s housing allowance and the rental value of parsonages are not included in a minister’s taxable income. Health 94. Employer-paid medical insurance and expenses.—Employer-paid health insurance premiums and other medical expenses (including long-term care) are deducted as a business expense by employers, but they are not included in employee gross income. The self-employed also may deduct part of their family health insurance premiums. 95. Self-employed medical insurance premiums.—Self-employed taxpayers may deduct a percentage of their family health insurance premiums. Taxpayers without self-employment income are not eligible for the special percentage deduction. The deductible percentage is 45 percent in 1998, 60 percent in 1999 through 2001, 70 percent in 2002, and 100 percent in 2003 and thereafter. 96. Workers’ compensation insurance premiums.—Workers’ compensation insurance premiums are paid by employers and deducted as a business expense, but the premiums are not included in employee gross income. 97. Medical savings accounts.—Some employees may deduct annual contributions to a medical savings account (MSA); employer contributions to MSAs (except those made through cafeteria plans) for qualified employees are also excluded from income. An employee may contribute to an MSA in a given year only if the employer does not contribute to the MSA in that year. MSAs are only available to self-employed individuals or employees covered under an employer-sponsored high deductible health plan of a small employer. The maximum annual MSA contribution is 75 percent of the deductible under the high deductible plan for family coverage (65 percent for individual coverage). Earnings from MSAs are excluded from taxable income. Distributions from an MSA for medical expenses are not taxable. The number of taxpayers who may benefit annually from MSAs is generally limited to 750,000. No new MSAs may be established after December 31, 2000. 98. Medical care expenses.—Personal expenditures for medical care (including the costs of prescription drugs) exceeding 7.5 percent of the taxpayer’s adjusted gross income are deductible. 99. Hospital construction bonds.—Interest earned on state and local government debt issued to finance hospital construction is excluded from income subject to tax. 100. Charitable contributions to health institutions.—Individuals and corporations may deduct contributions to nonprofit health institutions. Tax expenditures resulting from the deductibility of contributions to other charitable institutions are listed under the education, training, employment, and social services function. 101. Orphan drugs.—Drug firms can claim a tax credit of 50 percent of the costs for clinical testing required by the Food and Drug Administration for drugs that treat rare physical conditions or rare diseases. 102. Blue Cross and Blue Shield.—Blue Cross and Blue Shield health insurance providers in existence on August 16, 1986 and certain other nonprofit health insurers are provided exceptions from otherwise applicable insurance company income tax accounting rules that substantially reduce (or even eliminate) their tax liabilities. Income Security 103. Railroad retirement benefits.—Railroad retirement benefits are not generally subject to the income tax unless the recipient’s gross income reaches a certain threshold. The threshold is discussed more fully under the social security function. 104. Workers’ compensation benefits.—Workers— compensation provides payments to disabled workers. These benefits, although income to the recipients, are not subject to the income tax. Treasury reviewed the Federal income tax exemption for workers’ compensation wage replacement benefits as one of its pilot analyses of tax expenditures. Workers’ compensation programs, with the principal exception of the program covering Federal employees, are 5. TAX EXPENDITURES State programs that do not have to conform to any national criteria. While the legislative history does not explain the goal of the tax exemption, the exemption has the effect of reducing taxes on families with unexpected losses of earnings from work-related injuries or death. Because the tax exemption may have been considered in setting the levels of benefits mandated by State laws, the net benefit of the tax exemption to recipients is uncertain. 105. Public assistance benefits.—Public assistance benefits are excluded from tax. The normal tax method considers cash transfers from the government as taxable and, thus, treats the exclusion for public assistance benefits as a tax expenditure. 106. Special benefits for disabled coal miners.— Disability payments to former coal miners out of the Black Lung Trust Fund, although income to the recipient, are not subject to the income tax. 107. Military disability pensions.—Most of the military pension income received by current disabled retired veterans is excluded from their income subject to tax. 108. Employer-provided pension contributions and earnings.—Certain employer contributions to pension plans are excluded from an employee’s gross income even though the employer can deduct the contributions. In addition, the tax on the investment income earned by the pension plans is deferred until the money is withdrawn. 109. 401(k) plans and Individual Retirement Accounts.—Individual taxpayers can take advantage of several different tax-preferenced retirement plans: deductible IRAs, non-deductible IRAs, Roth IRAs, and 401(k) plans (and 401(k)-type plans like 403(b) plans and the government’s Thrift Savings Plan). In 1998, an employee could exclude up to $10,000 (indexed) of wages from AGI under a qualified arrangement with an employer’s 401(k). Employees can annually contribute to a deductible IRA up to $2,000 (or 100 percent of compensation, if less) or $4,000 on a joint return with only one working spouse if: (a) neither the individual nor spouse is an active participant in an employer-provided retirement plan, or (b) their AGI is below $40,000 ($25,000 for singles). The IRA deduction is phased out for taxpayers with AGI between $50,000 and $60,000 ($30,000 and $40,000 for singles). The phase-out range increases annually until it reaches $80,000 to $100,000 in 2007 ($50,000 to $60,000 for singles). Taxpayers whose AGI is above the start of the IRA phase-out range or who are active participants in an employer-provided retirement plan can contribute to a non-deductible IRA. The tax on the investment income earned by 401(k) plans, non-deductible IRAs, and deductible IRAs is deferred until the money is withdrawn. An employed taxpayer can make a non-deductible contribution of up to $2,000 (a non-employed spouse can also contribute up to $2,000 if a joint return is filed) to a Roth IRA. Investment income of a Roth IRA is not taxed when earned. Withdrawals from a Roth 133 IRA are tax free if (1) the Roth IRA was opened at least 5 years before the withdrawal, and (2) the taxpayer either (a) is at least 59–1⁄2, (b) dies, (c) is disabled, or (d) purchases a first-time house. The maximum contribution to a Roth IRA is phased out for taxpayers with AGI between $150,000 and $160,000 ($95,000 and $110,000 for singles). Total annual contributions to a taxpayer’s deductible, non-deductible, and Roth IRAs cannot exceed $2,000 ($4,000 for joints). 110. Keogh plans.—Self-employed individuals can make deductible contributions to their own retirement (Keogh) plans equal to 25 percent of their income, up to a maximum of $30,000 per year. In addition, the tax on the investment income earned by Keogh plans is deferred until the money is withdrawn. 111. Employer-provided life insurance benefits.— Employer-provided life insurance benefits are excluded from an employee’s gross income even though the employer’s costs for the insurance are a deductible business expense. 112. Employer-provided accident and disability benefits.—Employer-provided accident and disability benefits are excluded from an employee’s gross income even though the employer’s costs for the benefits are a deductible business expense. 113. Employer-provided supplementary unemployment benefits.—Employer-provided supplementary unemployment benefits are excluded from an employee’s gross income even though the employer’s costs for the benefits are a deductible business expense. 114. Employer Stock Ownership Plan (ESOP) provisions.—ESOPs are a special type of tax-exempt employee benefit plan. Employer-paid contributions (the value of stock issued to the ESOP) are deductible by the employer as part of employee compensation costs. They are not included in the employees’ gross income for tax purposes, however, until they are paid out as benefits. The following special income tax provisions for ESOPs are intended to increase ownership of corporations by their employees: (1) annual employer contributions are subject to less restrictive limitations; (2) ESOPs may borrow to purchase employer stock, guaranteed by their agreement with the employer that the debt will be serviced by his payment (deductible by him) of a portion of wages (excludable by the employees) to service the loan; (3) employees who sell appreciated company stock to the ESOP may defer any taxes due until they withdraw benefits; and (4) dividends paid to ESOP-held stock are deductible by the employer. 115. Additional deduction for the blind.—Taxpayers who are blind may take an additional $1,000 standard deduction if single, or $800 if married. 116. Additional deduction for the elderly.—Taxpayers who are 65 years or older may take an additional $1,000 standard deduction if single, or $800 if married. 117. Tax credit for the elderly and disabled.— Individuals who are 65 years of age or older, or who are permanently disabled, can take a tax credit equal 134 ANALYTICAL PERSPECTIVES to 15 percent of the sum of their earned and retirement income. Income is limited to no more than $5,000 for single individuals or married couples filing a joint return where only one spouse is 65 years of age or older, and up to $7,500 for joint returns where both spouses are 65 years of age or older. These limits are reduced by one-half of the taxpayer’s adjusted gross income over $7,500 for single individuals and $10,000 for married couples filing a joint return. 118. Casualty losses.—Neither the purchase of property nor insurance premiums to protect its value are deductible as costs of earning income; therefore, reimbursement for insured loss of such property is not reportable as a part of gross income. Taxpayers, however, may deduct uninsured casualty and theft losses of more than $100 each, but only to the extent that total losses during the year exceed 10 percent of AGI. 119. Earned income tax credit (EITC).—The EITC may be claimed by low income workers. For a family with one qualifying child, the credit is 34 percent of the first $6,680 of earned income in 1998. The credit is 40 percent of the first $9,390 of income for a family with two or more qualifying children. When the taxpayer’s income exceeds $12,260, the credit is phased out at the rate of 15.98 percent (21.06 percent if two or more qualifying children are present). It is completely phased out at $26,473 of modified adjusted gross income ($30,095 if two or more qualifying children are present). The credit may also be claimed by workers who do not have children living with them. Qualifying workers must be at least age 25 and may not be claimed as a dependent on another taxpayer’s return. The credit is not available to workers age 65 or older. In 1997, the credit is 7.65 percent of the first $4,460 of earned income. When the taxpayer’s income exceeds $5,570, the credit is phased out at the rate of 7.65 percent. It is completely phased out at $10,030 of modified adjusted gross income. For workers with or without children, the income level at which the credit’s phase-outs begin and the maximum amounts of income on which the credit can be taken are adjusted for inflation. Earned income tax credits in excess of tax liabilities owed through the individual income tax system are refundable to individuals. This portion of the credit is shown as an outlay, while the amount that offsets tax liabilities is shown as a tax expenditure. Social Security 120. Social Security benefits for retired workers.—Social security benefits that exceed the beneficiary’s contributions out of taxed income are deferred employee compensation and the deferral of tax on that compensation is a tax expenditure. These additional retirement benefits are paid for partly by employers’ contributions that were not included in employees’ taxable compensation. Portions (reaching as much as 85 percent) of recipients’ social security and tier 1 railroad retirement benefits are included in the income tax base, however, if the recipient’s provisional income exceeds certain base amounts. Provisional income is equal to adjusted gross income plus foreign or U.S. possession income and tax-exempt interest, and one half of social security and tier 1 railroad retirement benefits. The tax expenditure is limited to the portion of the benefits received by taxpayers who are below the base amounts at which 85 percent of the benefits are taxable. 121. Social Security benefits for the disabled.— Benefit payments from the Social Security Trust Fund, for disability and for dependents and survivors, are excluded from the beneficiaries’ gross incomes. 122. Social Security benefits for dependents and survivors.—Benefit payments from the Social Security Trust Fund for dependents and survivors are excluded from the beneficiaries’ gross income. Veterans Benefits and Services 123. Veterans death benefits and disability compensation.—All compensation due to death or disability paid by the Veterans Administration is excluded from taxable income. 124. Veterans pension payments.—Pension payments made by the Veterans Administration are excluded from gross income. 125. G.I. Bill benefits.—G.I. Bill benefits paid by the Veterans Administration are excluded from gross income. 126. Tax-exempt mortgage bonds for veterans.— Interest earned on general obligation bonds issued by State and local governments to finance housing for veterans is excluded from taxable income. The issuance of such bonds is limited, however, to five pre-existing State programs and to amounts based upon previous volume levels for the period January 1, 1979 to June 22, 1984. Furthermore, future issues are limited to veterans who served on active duty before 1977. General Government 127. Public purpose State and local bonds.—Interest earned on State and local government bonds issued to finance public purpose construction (e.g., schools, roads, sewers) is tax-exempt. 128. Deductibility of certain nonbusiness State and local taxes.—Taxpayers may deduct State and local income taxes and property taxes even though these taxes primarily pay for services that, if purchased directly by taxpayers, would not be deductible. 129. Business income earned in U.S. possessions.—U.S. corporations receiving income from investments or businesses located in a U.S. possession (e.g., Puerto Rico) can claim a credit against U.S. tax, which effectively excludes some of this income from tax. The credit expires December 31, 2005. Interest 130. U.S. savings bonds.—Taxpayers may defer paying tax on interest earned on U.S. savings bonds until the bonds are redeemed. 135 5. TAX EXPENDITURES TAX EXPENDITURES IN THE UNIFIED TRANSFER TAX Exceptions to the general terms of the Federal unified transfer tax favor particular transferees or dispositions of transferors, similar to Federal direct expenditure or loan programs. The transfer tax provisions identified as tax expenditures satisfy the reference law criteria for inclusion in the tax expenditure budget that were described above. There is no generally accepted normal tax baseline for transfer taxes. Unified Transfer Tax Reference Rules The reference tax rules for the unified transfer tax from which departures represent tax expenditures include: • Definition of the taxpaying unit. The payment of the tax is the liability of the transferor whether the transfer of cash or property was made by gift or bequest. • Definition of the tax base. The base for the tax is the transferor’s cumulative, taxable lifetime gifts made plus the net estate at death. Gifts in the tax base are all annual transfers in excess of $10,000 to any donee except the donor’s spouse. Excluded are, however, payments on behalf of family members’ educational and medical expenses, as well as the cost of ceremonial gatherings and celebrations that are not in honor of the donor. • Property valuation. In general, property is valued at its fair market value at the time it is transferred. This is not necessarily the case in the valuation of property for transfer tax purposes. Executors of estates are provided the option to value assets at the time of the testator’s death or up to six months later. • Tax rate schedule. A single graduated tax rate schedule applies to all taxable transfers. This is reflected in the name of the ‘‘unified transfer tax’’ that has replaced the former separate gift and estate taxes. The tax rates vary from 18 percent on the first $10,000 of aggregate taxable transfers, to 55 percent on amounts exceeding $3 million. A lifetime credit is provided against the tax in determining the final amount of transfer taxes that are due and payable. For decedents dying in 1998, this credit allows each taxpayer to make a $625,000 tax-free transfer of assets that otherwise would be liable to the unified transfer tax. This figure is scheduled to increase in steps to $1 million in 2005.11 • Time when tax is due and payable. Donors are required to pay the tax annually as gifts are made. The generation-skipping transfer tax is payable by the donees whenever they accede to the gift. The net estate tax liability is due and payable 11 An additional tax, at a flat rate of 55 percent, is imposed on lifetime, generationskipping transfers in excess of $1 million. It is considered a generation-skipping transfer whenever the transferee is at least two generations younger than the transferor, as it would be in the case of transfers to grandchildren or great-grandchildren. The liability of this tax is on the recipients of the transfer. within nine months after the decedent’s death. The Internal Revenue Service may grant an extension of up to 10 years for a reasonable cause. Interest is charged on the unpaid tax liability at a rate equal to the cost of Federal short-term borrowing, plus three percentage points. Tax Expenditures by Function The estimates of tax expenditures in the Federal unified transfer tax for fiscal years 1998–2004 are displayed by functional category in table 5–6. Outlay equivalent estimates are similar to revenue loss estimates for transfer tax expenditures and, therefore, are not shown separately. A description of the provisions follows. Natural Resources and Environment 1. Donations of conservation easements.—Bequests of property and easements (in perpetuity) for conservation purposes can be excluded from taxable estates. Use of the property and easements must be restricted to at least one of the following purposes: outdoor recreation or scenic enjoyment for the general public; protection of the natural habitats of fish, wildlife, plants, etc.; and preservation of historic land areas and structures. Conservation gifts are similarly excluded from the gift tax. Up to 40 percent of the value of land subject to certain conservation easements may be excluded from taxable estates; the maximum amount of the exclusion is $100,000 in 1998 and increases by $100,000 in each year through 2002. Agriculture 2. Special-use valuation of farms.—Up to $750,000 in farmland owned and operated by a decedent and/ or a member of the family may be valued for estate tax purposes on the basis of its ‘‘continued use’’ as farmland if: (1) the value of the farmland is at least 25 percent of the gross estate; (2) the entire value of all farm property is at least 50 percent of the gross estate; and (3) family heirs to the farm agree to continue to operate the property as a farm for at least 10 years. The $750,000 limit is indexed at 1998 levels, beginning in 1999. 3. Tax deferral of closely held farms.—The tax on a decedent’s farm can be deferred for up to 14 years if the value of the farm is at least 35 percent of the net estate. For the first 4 years of deferral, no tax need be paid. During the last 10 years of deferral, the tax liability must be paid in equal annual installments. Throughout the 14 year period, interest is charged at a special, favorable rate. For estates of decedents dying after December 31, 1997, the applicable interest rates are lower and the interest is non-deductible. Commerce and Housing 4. Special-use valuation of closely-held businesses.—The special-use valuation rule available for 136 ANALYTICAL PERSPECTIVES family farms is also available for nonfarm family businesses. To be eligible for the special-use valuation, the same three conditions previously described must be met. 5. Tax deferral of closely-held businesses.—The tax-deferral rule available for family farms is also available for nonfarm family businesses. To be eligible for the tax deferral, the value of stock in closely-held corporations must exceed 35 percent of the decedent’s gross estate, less debt and funeral expenses. 6. Exclusion for family-owned businesses.—Certain family-owned businesses that are bequeathed to qualified heirs can be excluded from taxable estates. The exclusion generally cannot exceed $1.3 million less the value of the unified credit. The exclusion is recaptured if certain conditions are not maintained for 10 years. Table 5–6. Education, Training, Employment, and Social Services 7. Charitable contributions to educational institutions.—Bequests to educational institutions can be deducted from taxable estates. 8. Charitable contributions, other than education and health.— Bequests to charitable, religious, and certain other nonprofit organizations can be deducted from taxable estates. Health 9. Charitable contributions to health institutions.—Bequests to health institutions can be deducted from taxable estates. General Government 10. State and local death taxes.—A credit against the federal estate tax is allowed for State taxes on bequests. The amount of this credit is determined by a rate schedule that reaches a maximum of 16 percent of the taxable estate in excess of $60,000. REVENUE LOSS ESTIMATES FOR TAX EXPENDITURES IN THE FEDERAL UNIFIED TRANSFER TAX (In millions of dollars) Description 1998 1999 2000 2001 2002 2003 2000– 2004 2004 1 Natural Resources and Environment: Donations of conservation easements .......................................................... 0 10 25 40 55 75 95 290 2 3 Agriculture: Special use valuation of farm real property .................................................. Tax deferral of closely held farms ................................................................. 80 0 95 0 110 0 115 5 120 5 125 10 135 10 605 30 4 5 6 Commerce: Special use valuation of real property used in closely held businesses ..... Tax deferral of closely held business ........................................................... Exclusion for family owned businesses ........................................................ 5 15 0 5 0 490 5 10 490 5 20 495 5 30 525 10 50 530 10 65 555 35 175 2,595 7 8 Education, training, employment, and social services: Deduction for charitable contributions (education) ........................................ Deduction for charitable contributions (other than education and health) ... 1,115 3,295 1,195 3,525 1,245 3,670 1,305 3,850 1,395 4,115 1,470 4,345 1,560 4,605 6,975 20,585 9 Health: Deduction for charitable contributions (health) ............................................. 1,010 1,080 1,125 1,180 1,260 1,330 1,410 6,305 10 General government: Credit for State death taxes .......................................................................... 4,650 4,970 5,175 5,410 5,670 5,965 6,200 28,420 SPECIAL ANALYSES AND PRESENTATIONS 137 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Investment spending is spending that yields longterm benefits. Its purpose may be to improve the efficiency of internal Federal agency operations or to increase the Nation’s overall stock of capital for economic growth. The spending can be direct Federal spending or grants to State and local governments. It can be for physical capital, which yields a stream of services over a period of years, or for research and development or education and training, which are intangible but also increase income in the future or provide other longterm benefits. Most presentations in the Federal budget combine investment spending with spending for current use. This chapter focuses solely on Federal and federally financed investment. These investments are discussed in the following sections: • a description of the size and composition of Federal investment spending; • a discussion of capital assets used to provide Federal services, and efforts to improve planning and budgeting for these assets. An Appendix to Part II presents the ‘‘Principles of Budgeting for Capital Asset Acquisitions,’’ which are being used to guide the analysis of Administration requests for spending for capital assets; • a presentation of trends in the stock of federally financed physical capital, research and development, and education; • alternative capital budget and capital expenditure presentations; and • projections of Federal physical capital outlays and recent assessments of public civilian capital needs, as required by the Federal Capital Investment Program Information Act of 1984. The President established a Commission to Study Capital Budgeting in 1997, and the Commission is scheduled to transmit its report to the National Economic Council in early 1999. The Administration looks forward to receipt of the report and will review its analysis and recommendations on how to improve the planning, budgeting, and use of capital in the Federal Government. Part I: DESCRIPTION OF FEDERAL INVESTMENT For almost fifty years, a chapter in the budget has shown Federal investment outlays—defined as those outlays that yield long-term benefits—separately from outlays for current use. Again this year the discussion of the composition of investment includes estimates of budget authority as well as outlays and extends these estimates four years beyond the budget year, to 2004. The classification of spending between investment and current outlays is a matter of judgment. The budget has historically employed a relatively broad classification, including physical investment, research, development, education, and training. The budget further classifies investments into those that are grants to State and local governments, such as grants for highways or for elementary and secondary education, and all other investments, called ‘‘direct Federal programs,’’ in this analysis. This ‘‘direct Federal’’ category consists primarily of spending for assets owned by the Federal Government, such as defense weapons systems and general purpose office buildings, but also includes grants to private organizations and individuals for investment, such as capital grants to Amtrak or higher education loans directly to individuals. Presentations for particular purposes could adopt different definitions of investment: • To suit the purposes of a traditional balance sheet, investment might include only those physical assets owned by the Federal Government, excluding capital financed through grants and intangible assets such as research and education. • Focusing on the role of investment in improving national productivity and enhancing economic growth would exclude items such as national defense assets, the direct benefits of which enhance national security rather than economic growth. • Concern with the efficiency of Federal operations would confine the coverage to investments that reduce costs or improve the effectiveness of internal Federal agency operations, such as computer systems. • A ‘‘social investment’’ perspective might broaden the coverage of investment beyond what is included in this chapter to encompass programs such as childhood immunization, maternal health, certain nutrition programs, and substance abuse treatment, which are designed in part to prevent more costly health problems in future years. The relatively broad definition of investment used in this section provides consistency over time—historical figures on investment outlays back to 1940 can be found in the separate Historical Tables volume. The detailed tables at the end of this section allow disaggregation of the data to focus on those investment outlays that best suit a particular purpose. In addition to this basic issue of definition, there are two technical problems in the classification of investment data, involving the treatment of grants to 139 140 State and local governments and the classification of spending that could be shown in more than one category. First, for some grants to State and local governments it is the recipient jurisdiction, not the Federal Government, that ultimately determines whether the money is used to finance investment or current purposes. This analysis classifies all of the outlays in the category where the recipient jurisdictions are expected to spend most of the money. Hence, the community development block grants are classified as physical investment, although some may be spent for current purposes. General purpose fiscal assistance is classified as current spending, although some may be spent by recipient jurisdictions on physical investment. Second, some spending could be classified in more than one category of investment. For example, outlays for construction of research facilities finance the acquisition of physical assets, but they also contribute to research and development. To avoid double counting, the outlays are classified in the category that is most commonly recognized as investment. Consequently outlays for the conduct of research and development do not include outlays for research facilities, because these outlays are included in the category for physical investment. Similarly, physical investment and research and development related to education and training are included in the categories of physical assets and the conduct of research and development. When direct loans and loan guarantees are used to fund investment, the subsidy value is included as investment. The subsidies are classified according to their program purpose, such as construction, education and training, or non-investment outlays. For more information about the treatment of Federal credit programs, refer to Chapter 8, ‘‘Underwriting Federal Credit and Insurance.’’ This section presents spending for gross investment, without adjusting for depreciation. A subsequent section discusses depreciation, shows investment both gross and net of depreciation, and displays net capital stocks. Composition of Federal Investment Outlays Major Federal Investment The composition of major Federal investment outlays is summarized in Table 6–1. They include major public physical investment, the conduct of research and development, and the conduct of education and training. Defense and nondefense investment outlays were $228.0 billion in 1998. They are estimated to increase to $243.9 billion in 1999 and to increase further to $247.3 billion in 2000. Major Federal investment will comprise an estimated 14.0 percent of total Federal outlays in 2000 and 2.7 percent of the Nation’s gross domestic product (GDP). Greater detail on Federal investment is available in tables 6–2 and 6–3 at the end of this section. Those tables include both budget authority and outlays. Physical investment.—Outlays for major public physical capital investment (hereafter referred to as physical ANALYTICAL PERSPECTIVES investment outlays) are estimated to be $121.2 billion in 2000. Physical investment outlays are for construction and rehabilitation, the purchase of major equipment, and the purchase or sale of land and structures. Three-fifths of these outlays are for direct physical investment by the Federal Government, with the remaining being grants to State and local governments for physical investment. Direct physical investment outlays by the Federal Government are primarily for national defense. Defense outlays for physical investment were $53.5 billion in 1998 and are estimated to decline slightly to $51.6 billion in 2000. Almost all of these outlays, or $46.9 billion, are for the procurement of weapons and other defense equipment, and the remainder is primarily for construction on military bases, family housing for military personnel, and Department of Energy defense facilities. These outlays will begin to increase in 2001 in response to increases in defense budget authority requested for 2000 and later years in this budget. The increases in budget authority are discussed in Chapter 11 of the Budget volume. Outlays for direct physical investment for nondefense purposes are estimated to be $21.2 billion in 2000. These outlays include $13.0 billion for construction and rehabilitation. This amount funds water, power, and natural resources projects of the Army Corps of Engineers, the Bureau of Reclamation within the Department of the Interior, the Tennessee Valley Authority, and the power administrations in the Department of Energy; construction and rehabilitation of veterans hospitals and Postal Service facilities; and facilities for space and science programs. Outlays for the acquisition of major equipment are estimated to be $7.6 billion in 2000. The largest amounts are for the air traffic control system and the Postal Service. For the purchase or sale of land and structures, collections exceeded disbursements by $4.6 billion in 1998, largely due to the sale of the United States Enrichment Corporation and the privatization of Elk Hills. These sales explain most of the increase in outlays in this category from 1998 to 1999. Grants to State and local governments for physical investment are estimated to be $48.4 billion in 2000. Almost two-thirds of these outlays, or $31.0 billion, are to assist States and localities with transportation infrastructure, primarily highways. Other major grants for physical investment fund sewage treatment plants, community development, and public housing. Conduct of research and development.—Outlays for the conduct of research and development are estimated to be $73.6 billion in 2000. These outlays are devoted to increasing basic scientific knowledge and promoting research and development. They increase the Nation’s security, improve the productivity of capital and labor for both public and private purposes, and enhance the quality of life. Slightly more than half of these outlays, an estimated $37.7 billion in 2000, are for national defense. Physical investment for research and develop- 6. 141 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Table 6–1. COMPOSITION OF FEDERAL INVESTMENT OUTLAYS (In billions of dollars) 1998 actual Estimate 1999 2000 Federal Investment Major public physical capital investment: Direct Federal: National defense ................................................................................................. Nondefense .......................................................................................................... 53.5 15.1 53.5 20.8 51.6 21.2 Subtotal, direct major public physical capital investment .............................. Grants to State and local governments ....................................................................... 68.7 41.1 74.2 44.9 72.8 48.4 Subtotal, major public physical capital investment ......................................... Conduct of research and development: National defense ....................................................................................................... Nondefense ............................................................................................................... 109.8 119.1 121.2 40.1 32.7 39.6 34.5 37.7 35.9 72.8 74.2 73.6 Conduct of education and training: Grants to State and local governments ................................................................... Direct Federal .......................................................................................................... Subtotal, conduct of research and development ........................................... 26.5 19.0 28.8 21.8 32.4 20.0 Subtotal, conduct of education and training ................................................... 45.4 50.6 52.5 Major Federal investment outlays ............................................................................. MEMORANDUM Major Federal investment outlays: National defense ....................................................................................................... Nondefense ............................................................................................................... 228.0 243.9 247.3 93.7 134.3 93.1 150.8 89.3 158.0 228.0 243.9 247.3 –0.4 3.0 0.1 3.3 –0.3 3.1 2.6 3.4 2.9 230.6 247.3 250.1 Total, major Federal investment outlays .............................................................. Miscellaneous physical investments: Commodity inventories ............................................................................................ Other physical investment (direct) ............................................................................ Total, miscellaneous physical investment .......................................................... Total, Federal investment outlays, including miscellaneous physical investment ....... ment facilities and equipment is included in the physical investment category. Nondefense outlays for the conduct of research and development are estimated to be $35.9 billion in 2000. This is almost entirely direct spending by the Federal Government, and is largely for the space programs, the National Science Foundation, the National Institutes of Health, and research for nuclear and non-nuclear energy programs. Conduct of education and training.—Outlays for the conduct of education and training are estimated to be $52.5 billion in 2000. These outlays add to the stock of human capital by developing a more skilled and productive labor force. Grants to State and local governments for this category are estimated to be $32.4 billion in 2000, more than three-fifths of the total. They include education programs for the disadvantaged and the handicapped, vocational and adult education programs, training programs in the Department of Labor, and Head Start. Direct education and training outlays by the Federal Government are estimated to be $20.0 billion in 2000. Programs in this category are primarily aid for higher education through student financial assistance, loan subsidies, the veterans GI bill, and health training programs. This category does not include outlays for education and training of Federal civilian and military employees. Outlays for education and training that are for physical investment and for research and development are in the categories for physical investment and the conduct of research and development. Miscellaneous Physical Investment Outlays In addition to the categories of major Federal investment, several miscellaneous categories of investment outlays are shown at the bottom of Table 6–1. These items, all for physical investment, are generally unrelated to improving Government operations or enhancing economic activity. 142 ANALYTICAL PERSPECTIVES Outlays for commodity inventories are for the purchase or sale of agricultural products pursuant to farm price support programs and the purchase and sale of other commodities such as oil and gas. Sales are estimated to exceed purchases by $0.3 billion in 2000. Outlays for other miscellaneous physical investment are estimated to be $3.1 billion in 2000. This category includes primarily conservation programs. These outlays are entirely for direct Federal spending. Detailed Tables on Investment Spending This section provides data on budget authority as well as outlays for major Federal investment. These estimates extend four years beyond the budget year to 2004. Table 6–2 displays budget authority (BA) and outlays (O) by major programs according to defense and nondefense categories. The greatest level of detail appears in Table 6–3, which shows budget authority and outlays divided according to grants to State and local governments and direct Federal spending. Miscellaneous investment is not included in these tables because it is generally unrelated to improving Government operations or enhancing economic activity. 6. 143 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Table 6–2. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: DEFENSE AND NONDEFENSE PROGRAMS (in millions of dollars) 1998 Actual Description Estimate 1999 2000 2001 2002 2003 2004 4,866 5,092 45,263 48,492 –34 –34 4,794 4,716 48,915 48,778 –36 –36 2,318 4,461 52,833 47,207 –36 –36 7,124 3,882 61,789 51,553 –36 –36 3,951 4,988 62,115 55,038 –36 –36 4,048 4,693 66,369 59,961 –36 –36 4,159 4,326 69,033 63,851 –36 –36 BA O 50,095 53,550 53,673 53,458 55,115 51,632 68,877 55,399 66,030 59,990 70,381 64,618 73,156 68,141 Conduct of research and development ............................................................. BA O Conduct of education and training (civilian) ..................................................... BA O 39,824 40,141 2 8 39,819 39,612 3 3 37,712 37,662 8 6 37,597 37,764 8 8 37,975 37,779 10 9 37,829 37,792 10 10 38,337 38,091 10 10 Subtotal, national defense investment ..................................................... BA O NONDEFENSE Major public physical investment: Construction and rehabilitation: Highways ................................................................................................... BA O Mass transportation ................................................................................... BA O Rail transportation ..................................................................................... BA O Air transportation ....................................................................................... BA O Community development block grants ..................................................... BA O Other community and regional development ........................................... BA O Pollution control and abatement ............................................................... BA O Water resources ........................................................................................ BA O Housing assistance ................................................................................... BA O Energy ........................................................................................................ BA O Veterans hospitals and other health ......................................................... BA O Postal Service ............................................................................................ BA O GSA real property activities ...................................................................... BA O Other programs ......................................................................................... BA O 89,921 93,699 93,495 93,073 92,835 89,300 106,482 93,171 104,015 97,778 108,220 102,420 111,503 106,242 24,868 20,063 4,602 3,892 271 465 1,657 1,541 4,925 4,621 1,465 1,479 4,131 3,521 2,650 2,350 6,219 6,406 779 778 1,660 1,565 1,726 1,528 238 1,375 3,764 3,718 29,385 23,150 4,830 3,789 6 107 2,336 1,684 4,873 4,965 1,560 1,438 4,169 3,616 2,967 3,297 6,982 6,501 960 961 1,662 1,633 1,654 1,032 1,165 1,069 3,111 3,044 30,664 25,517 5,906 3,960 11 16 1,616 1,766 4,775 4,856 1,669 1,414 3,613 4,104 3,039 3,295 6,559 7,264 843 843 1,453 1,652 1,457 1,225 767 1,016 2,748 3,330 30,144 26,762 6,086 4,763 11 10 1,617 1,697 4,775 4,817 1,669 1,522 3,615 4,205 3,037 3,176 6,559 8,178 721 719 1,493 1,657 1,317 1,344 952 1,079 2,919 2,910 30,692 26,955 6,552 5,299 11 11 1,618 1,659 4,775 4,792 1,669 1,788 3,615 4,032 3,023 2,936 6,559 8,175 930 928 1,475 1,628 1,485 1,457 875 1,062 2,801 2,935 31,237 27,154 7,019 5,984 11 11 1,619 1,648 4,775 4,757 1,669 1,853 3,615 4,010 3,031 3,079 6,559 8,249 892 890 1,466 1,586 1,742 1,574 918 1,016 2,578 2,973 31,876 27,698 7,168 6,404 11 11 1,619 1,641 4,775 4,779 1,669 1,826 3,615 4,005 3,045 3,060 6,559 8,287 672 670 1,466 1,577 1,509 1,609 847 939 2,680 2,742 BA O 58,955 53,302 65,660 56,286 65,120 60,258 64,915 62,839 66,080 63,657 67,131 64,784 67,511 65,248 BA O BA O BA O 1,948 2,285 597 364 4,877 3,969 2,096 1,952 739 319 5,839 4,788 2,320 2,019 848 736 4,964 4,941 2,486 2,184 918 802 5,547 5,446 2,626 2,360 744 781 5,488 5,601 2,792 2,606 744 590 5,447 5,615 2,927 2,758 530 835 5,405 5,604 BA O 7,422 6,618 8,674 7,059 8,132 7,696 8,951 8,432 8,858 8,742 8,983 8,811 8,862 9,197 Purchase or sale of land and structures ...................................................... BA O –3,966 –4,613 626 1,265 398 525 720 765 223 244 719 748 712 721 NATIONAL DEFENSE Major public physical investment: Construction and rehabilitation ...................................................................... BA O Acquisition of major equipment ..................................................................... BA O Purchase or sale of land and structures ...................................................... BA O Subtotal, major public physical investment .............................................. Subtotal, construction and rehabilitation .............................................. Acquisition of major equipment: Air transportation ....................................................................................... Postal Service ............................................................................................ Other .......................................................................................................... Subtotal, acquisition of major equipment ............................................. 144 ANALYTICAL PERSPECTIVES Table 6–2. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: DEFENSE AND NONDEFENSE PROGRAMS—Continued (in millions of dollars) 1998 Actual Description Other physical assets (grants) ...................................................................... BA O Estimate 1999 2000 2001 2002 2003 2004 942 917 941 1,075 1,327 1,086 1,314 1,264 1,342 1,261 1,388 1,313 1,477 1,363 BA O 63,353 56,224 75,901 65,685 74,977 69,565 75,900 73,300 76,503 73,904 78,221 75,656 78,562 76,529 BA O BA O BA O BA O BA O BA O 12,367 12,503 1,281 1,526 1,826 1,778 13,543 12,471 1,936 1,653 2,791 2,731 12,970 12,858 1,230 1,368 1,678 1,699 15,471 13,903 2,011 1,785 3,128 2,931 13,409 12,907 1,346 1,365 1,581 1,698 15,821 15,371 1,953 1,767 2,902 2,834 13,588 13,291 1,324 1,516 1,597 1,716 16,001 15,935 1,953 1,757 2,913 2,886 13,657 13,480 1,324 1,517 1,640 1,693 16,061 16,045 1,953 1,758 3,027 3,053 13,847 13,768 1,324 1,487 1,662 1,748 16,085 16,076 1,953 1,768 2,993 3,011 13,907 13,926 1,324 1,419 1,687 1,771 15,785 15,768 1,953 1,770 3,022 3,031 BA O 33,744 32,662 36,488 34,544 37,012 35,942 37,376 37,101 37,662 37,546 37,864 37,858 37,678 37,685 BA O Higher education ....................................................................................... BA O Research and general education aids ...................................................... BA O Training and employment ......................................................................... BA O Social services ........................................................................................... BA O 18,738 16,507 13,818 12,060 1,900 1,958 6,370 4,569 6,994 6,610 16,761 16,910 14,248 14,032 2,233 2,128 6,608 5,938 7,366 7,454 20,762 20,041 12,332 11,636 2,300 2,415 6,435 6,645 8,026 7,554 22,687 22,527 13,610 13,427 2,304 2,413 5,433 6,378 8,087 7,903 22,687 22,750 12,666 12,157 2,320 2,432 5,386 5,740 8,149 7,993 22,687 22,837 13,954 13,623 2,279 2,399 5,386 5,413 8,213 8,036 22,687 22,849 14,599 14,175 2,268 2,407 5,386 5,381 8,279 8,102 BA O 47,820 41,704 47,216 46,462 49,855 48,291 52,121 52,648 51,208 51,072 52,519 52,308 53,219 52,914 Veterans education, training, and rehabilitation ........................................... BA O Health ............................................................................................................. BA O Other education and training ......................................................................... BA O 1,568 1,502 871 808 1,503 1,408 1,357 1,693 1,003 932 1,535 1,468 1,652 1,681 951 957 1,578 1,521 1,908 1,937 948 956 1,578 1,557 1,902 1,909 946 948 1,555 1,561 1,901 1,906 940 942 1,557 1,560 1,927 1,933 935 936 1,559 1,564 Subtotal, conduct of education and training ............................................ BA O 51,762 45,422 51,111 50,555 54,036 52,450 56,555 57,098 55,611 55,490 56,917 56,716 57,640 57,347 BA O 148,859 134,308 163,500 150,784 166,025 157,957 169,831 167,499 169,776 166,940 173,002 170,230 173,880 171,561 Total, Federal investment ............................................................................... BA O 238,780 228,007 256,995 243,857 258,860 247,257 276,313 260,670 273,791 264,718 281,222 272,650 285,383 277,803 Subtotal, major public physical investment .............................................. Conduct of research and development: General science, space and technology ....................................................... Energy ............................................................................................................ Transportation ................................................................................................ Health ............................................................................................................. Natural resources and environment .............................................................. All other research and development ............................................................. Subtotal, conduct of research and development ..................................... Conduct of education and training: Education, training, employment and social services: Elementary, secondary, and vocational education ................................... Subtotal, education, training, and social services ............................... Subtotal, nondefense investment .............................................................. 6. 145 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Table 6–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS (in millions of dollars) Description GRANTS TO STATE AND LOCAL GOVERNMENTS Major public physical investments: Construction and rehabilitation: Highways ................................................................................................... BA O Mass transportation ................................................................................... BA O Rail transportation ..................................................................................... BA O Air transportation ....................................................................................... BA O Pollution control and abatement ............................................................... BA O Other natural resources and environment ................................................ BA O Community development block grants ..................................................... BA O Other community and regional development ........................................... BA O Housing assistance ................................................................................... BA O National defense ........................................................................................ BA O Other construction ..................................................................................... BA O Estimate 1998 Actual 1999 2000 2001 2002 2003 2004 24,691 20,036 4,602 3,892 10 44 1,640 1,511 2,730 2,084 43 65 4,925 4,621 1,084 1,060 6,193 6,388 .................. 5 460 427 29,008 23,057 4,834 3,789 .................. 47 2,322 1,670 2,783 2,188 27 96 4,873 4,965 1,327 1,284 6,956 6,475 .................. 3 166 194 30,453 25,320 5,906 3,960 .................. 2 1,600 1,750 2,149 2,558 26 67 4,775 4,856 1,423 1,274 6,529 7,237 .................. .................. 119 206 29,937 26,558 6,086 4,763 .................. .................. 1,600 1,680 2,149 2,675 26 44 4,775 4,817 1,423 1,365 6,529 8,148 .................. .................. 119 181 30,481 26,750 6,552 5,299 .................. .................. 1,600 1,641 2,149 2,493 26 34 4,775 4,792 1,423 1,493 6,529 8,145 .................. .................. 119 145 31,022 26,948 7,019 5,984 .................. .................. 1,600 1,628 2,149 2,435 26 34 4,775 4,757 1,423 1,547 6,529 8,219 .................. .................. 119 119 31,657 27,487 7,168 6,404 .................. .................. 1,600 1,620 2,149 2,394 26 34 4,775 4,779 1,423 1,520 6,529 8,257 .................. .................. 119 119 Subtotal, construction and rehabilitation .............................................. BA O 46,378 40,133 52,296 43,768 52,980 47,230 52,644 50,231 53,654 50,792 54,662 51,671 55,446 52,614 Other physical assets .................................................................................... BA O 996 972 1,027 1,161 1,402 1,178 1,462 1,348 1,480 1,373 1,515 1,436 1,533 1,485 Subtotal, major public physical capital ..................................................... BA O 47,374 41,105 53,323 44,929 54,382 48,408 54,106 51,579 55,134 52,165 56,177 53,107 56,979 54,099 BA O BA O 223 223 121 79 253 226 154 105 181 220 168 182 189 237 164 187 189 258 167 188 189 254 169 190 189 251 172 193 BA O 344 302 407 331 349 402 353 424 356 446 358 444 361 444 Conduct of education and training: Elementary, secondary, and vocational education ....................................... BA O Higher education ............................................................................................ BA O Research and general education aids .......................................................... BA O Training and employment .............................................................................. BA O Social services ............................................................................................... BA O Agriculture ...................................................................................................... BA O Other .............................................................................................................. BA O 17,714 15,686 80 90 328 378 5,122 3,463 6,722 6,354 423 416 87 82 15,504 15,992 160 65 516 389 5,043 4,639 7,081 7,153 453 438 80 80 18,611 18,752 197 122 347 479 4,749 5,304 7,721 7,258 402 433 82 79 20,536 20,692 197 141 362 468 3,748 4,961 7,782 7,598 402 410 82 81 20,536 20,724 197 144 366 462 3,715 4,309 7,844 7,688 402 405 82 82 20,536 20,776 197 144 347 447 3,715 3,979 7,908 7,731 402 402 82 80 20,536 20,787 197 144 340 445 3,715 3,951 7,974 7,797 402 402 82 81 Subtotal, conduct of education and training ............................................ BA O 30,476 26,469 28,837 28,756 32,109 32,427 33,109 34,351 33,142 33,814 33,187 33,559 33,246 33,607 78,194 67,876 82,567 74,016 86,840 81,237 87,568 86,354 88,632 86,425 89,722 87,110 90,586 88,150 Conduct of research and development: Agriculture ...................................................................................................... Other .............................................................................................................. Subtotal, conduct of research and development ..................................... Subtotal, grants for investment ................................................................. BA O 146 ANALYTICAL PERSPECTIVES Table 6–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS—Continued (in millions of dollars) 1998 Actual Description DIRECT FEDERAL PROGRAMS Major public physical investment: Construction and rehabilitation: National defense: Military construction .............................................................................. Estimate 1999 2000 2001 2002 2003 2004 BA O BA O BA O 3,281 3,515 887 883 698 689 3,309 3,107 739 966 746 640 1,433 2,955 206 803 679 703 5,328 2,526 937 602 859 754 2,646 3,730 446 484 859 774 2,742 3,433 447 489 859 771 2,852 3,055 448 500 859 771 BA O 4,866 5,087 4,794 4,713 2,318 4,461 7,124 3,882 3,951 4,988 4,048 4,693 4,159 4,326 BA O General science, space, and technology ................................................. BA O Water resources projects .......................................................................... BA O Other natural resources and environment ................................................ BA O Energy ........................................................................................................ BA O Postal Service ............................................................................................ BA O Transportation ............................................................................................ BA O Housing assistance ................................................................................... BA O Veterans hospitals and other health facilities .......................................... BA O Federal Prison System .............................................................................. BA O GSA real property activities ...................................................................... BA O Other construction ..................................................................................... BA O 213 150 375 517 2,607 2,287 1,782 1,799 779 778 1,726 1,528 596 664 26 18 1,580 1,515 151 33 416 1,640 2,326 2,245 513 318 465 479 2,940 3,204 1,756 1,788 960 961 1,654 1,032 628 344 26 26 1,572 1,581 323 459 1,165 1,069 1,362 1,260 341 392 524 551 3,017 3,233 1,793 1,895 843 843 1,457 1,225 296 361 30 27 1,413 1,588 439 414 767 1,016 1,220 1,483 539 455 536 511 3,015 3,137 1,854 1,926 721 719 1,317 1,344 206 205 30 30 1,453 1,594 432 477 952 1,079 1,216 1,131 639 488 541 515 3,001 2,907 1,826 1,930 930 928 1,485 1,457 211 207 30 30 1,435 1,562 342 477 875 1,062 1,111 1,302 738 553 536 518 3,009 3,050 1,828 1,976 892 890 1,742 1,574 216 204 30 30 1,426 1,546 22 434 918 1,016 1,112 1,322 837 639 539 518 3,023 3,031 1,828 2,017 672 670 1,509 1,609 220 214 30 30 1,426 1,537 22 186 847 939 1,112 1,244 BA O 17,443 18,261 18,158 17,234 14,458 17,489 19,395 16,490 16,377 17,853 16,517 17,806 16,224 16,960 BA O BA O 44,934 48,180 329 312 48,562 48,422 353 356 52,483 46,864 350 343 61,439 51,199 350 354 61,765 54,686 350 352 66,019 59,610 350 351 68,683 63,500 350 351 BA O 45,263 48,492 48,915 48,778 52,833 47,207 61,789 51,553 62,115 55,038 66,369 59,961 69,033 63,851 BA O Space flight, research, and supporting activities ..................................... BA O Energy ........................................................................................................ BA O Postal Service ............................................................................................ BA O Air transportation ....................................................................................... BA O Water transportation (Coast Guard) ......................................................... BA O Other transportation (railroads) ................................................................. BA O Social security ........................................................................................... BA 386 378 657 662 125 124 597 364 1,948 2,285 263 187 .................. 164 50 368 341 659 668 125 125 739 319 2,096 1,952 423 272 609 247 .................. 396 375 509 499 121 121 848 736 2,320 2,019 231 325 571 442 .................. 443 392 506 502 118 118 918 802 2,486 2,184 318 274 571 581 .................. 429 422 491 493 105 105 744 781 2,626 2,360 318 309 571 572 .................. 407 431 471 478 72 72 744 590 2,792 2,606 318 309 571 572 .................. 408 421 462 467 72 72 530 835 2,927 2,758 318 318 571 572 .................. Family housing ...................................................................................... Atomic energy defense activities and other ......................................... Subtotal, national defense ................................................................ International affairs .................................................................................... Subtotal, construction and rehabilitation .............................................. Acquisition of major equipment: National defense: Department of Defense ........................................................................ Atomic energy defense activities .......................................................... Subtotal, national defense ................................................................ General science and basic research ........................................................ 6. 147 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Table 6–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS—Continued (in millions of dollars) 1998 Actual Description Estimate 1999 2000 2001 2002 2003 2004 O BA O BA O BA O BA O BA O 87 700 475 523 453 919 578 513 493 687 313 55 684 542 464 436 858 644 657 657 906 715 30 500 556 550 505 394 522 657 657 960 817 32 504 571 551 560 727 734 654 654 1,007 944 34 510 575 549 577 724 749 681 681 972 972 37 511 579 549 580 727 716 735 735 959 983 40 512 580 549 580 731 709 737 737 989 986 BA O 52,631 55,055 57,503 55,751 60,890 54,811 70,592 59,901 70,835 63,668 75,225 68,649 77,839 72,926 BA O International affairs .................................................................................... BA O Sale of the United States Enrichment Corporation ................................. BA O Privatization of Elk Hills ............................................................................ BA O Other .......................................................................................................... BA O –34 –34 10 13 –1,885 –1,885 –2,887 –2,887 796 146 –36 –36 19 19 .................. .................. .................. .................. 607 1,246 –36 –36 14 21 .................. .................. –323 –323 707 827 –36 –36 19 23 .................. .................. .................. .................. 701 742 –36 –36 23 24 .................. .................. .................. .................. 200 220 –36 –36 27 28 .................. .................. .................. .................. 692 720 –36 –36 31 32 .................. .................. .................. .................. 681 689 Subtotal, purchase or sale of land and structures .............................. BA O –4,000 –4,647 590 1,229 362 489 684 729 187 208 683 712 676 685 BA O 66,074 68,669 76,251 74,214 75,710 72,789 90,671 77,120 87,399 81,729 92,425 87,167 94,739 90,571 BA O Atomic energy and other .......................................................................... BA O 37,230 37,558 2,594 2,583 36,895 36,875 2,924 2,737 34,794 34,723 2,918 2,939 34,679 34,748 2,918 3,016 35,057 34,777 2,918 3,002 34,911 34,815 2,918 2,977 35,419 35,114 2,918 2,977 BA O 39,824 40,141 39,819 39,612 37,712 37,662 37,597 37,764 37,975 37,779 37,829 37,792 38,337 38,091 International affairs ........................................................................................ BA O General science, space and technology NASA ......................................................................................................... BA O National Science Foundation .................................................................... BA O Department of Energy ............................................................................... BA O 163 233 165 201 115 182 115 185 115 197 115 199 115 199 8,200 8,631 2,293 2,010 1,874 1,862 8,237 8,475 2,507 2,125 2,226 2,258 8,422 8,201 2,734 2,437 2,253 2,269 8,607 8,355 2,728 2,603 2,253 2,333 8,684 8,417 2,720 2,722 2,253 2,341 8,874 8,716 2,720 2,711 2,253 2,341 8,934 8,861 2,720 2,724 2,253 2,341 Subtotal, general science, space and technology ............................... BA O 12,530 12,736 13,135 13,059 13,524 13,089 13,703 13,476 13,772 13,677 13,962 13,967 14,022 14,125 BA O 1,281 1,526 1,230 1,368 1,346 1,365 1,324 1,516 1,324 1,517 1,324 1,487 1,324 1,419 BA O BA O 471 475 1,262 1,250 416 424 1,144 1,198 436 488 1,020 1,054 431 526 1,043 1,027 446 488 1,068 1,041 466 510 1,068 1,072 482 524 1,074 1,078 BA O 3,014 3,251 2,790 2,990 2,802 2,907 2,798 3,069 2,838 3,046 2,858 3,069 2,880 3,021 Hospital and medical care for veterans ................................................... Department of Justice ............................................................................... Department of the Treasury ...................................................................... GSA general supply fund .......................................................................... Other .......................................................................................................... Subtotal, acquisition of major equipment ............................................. Purchase or sale of land and structures: National defense ........................................................................................ Subtotal, major public physical investment .............................................. Conduct of research and development: National defense Defense military ......................................................................................... Subtotal, national defense .................................................................... Energy ............................................................................................................ Transportation: Department of Transportation ................................................................... NASA ......................................................................................................... Subtotal, transportation ......................................................................... 148 ANALYTICAL PERSPECTIVES Table 6–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS—Continued (in millions of dollars) 1998 Actual Description Health: National Institutes of Health ...................................................................... Estimate 1999 2000 2001 2002 2003 2004 BA O BA O 12,898 11,853 633 606 14,783 13,213 675 677 15,150 14,600 658 758 15,150 15,020 838 902 15,150 15,076 898 956 15,124 15,059 948 1,004 15,124 15,055 648 700 Subtotal, health ..................................................................................... BA O 13,531 12,459 15,458 13,890 15,808 15,358 15,988 15,922 16,048 16,032 16,072 16,063 15,772 15,755 Agriculture ...................................................................................................... BA O BA O BA O BA O BA O 1,026 977 1,936 1,653 392 423 272 247 699 614 1,235 1,083 2,011 1,785 395 431 316 305 741 670 1,204 1,116 1,953 1,767 432 423 316 314 624 566 1,204 1,132 1,953 1,757 432 432 316 315 629 574 1,205 1,147 1,953 1,758 432 440 316 315 742 685 1,208 1,144 1,953 1,768 432 439 316 315 705 649 1,208 1,140 1,953 1,770 432 437 316 315 734 678 BA O 73,224 72,501 75,900 73,825 74,375 73,202 74,620 74,441 75,281 74,879 75,335 75,206 75,654 75,332 Conduct of education and training: Elementary, secondary, and vocational education ....................................... BA O Higher education ............................................................................................ BA O Research and general education aids .......................................................... BA O Training and employment .............................................................................. BA O Health ............................................................................................................. BA O Veterans education, training, and rehabilitation ........................................... BA O General science and basic reserach ............................................................ BA O National defense ............................................................................................ BA O International affairs ........................................................................................ BA O Other .............................................................................................................. BA O 1,024 821 13,738 11,970 1,572 1,580 1,248 1,106 871 808 1,568 1,502 599 543 2 8 269 252 397 371 1,257 918 14,088 13,967 1,717 1,739 1,565 1,299 1,003 932 1,357 1,693 660 586 3 3 201 230 426 435 2,151 1,289 12,135 11,514 1,953 1,936 1,686 1,341 951 957 1,652 1,681 686 639 8 6 211 213 502 453 2,151 1,835 13,413 13,286 1,942 1,945 1,685 1,417 948 956 1,908 1,937 684 667 8 8 211 217 504 487 2,151 2,026 12,469 12,013 1,954 1,970 1,671 1,431 946 948 1,902 1,909 659 653 10 9 211 211 506 515 2,151 2,061 13,757 13,479 1,932 1,952 1,671 1,434 940 942 1,901 1,906 659 657 10 10 211 211 508 515 2,151 2,062 14,402 14,031 1,928 1,962 1,671 1,430 935 936 1,927 1,933 659 659 10 10 211 211 510 516 Subtotal, conduct of education and training ............................................ BA O 21,288 18,961 22,277 21,802 21,935 20,029 23,454 22,755 22,479 21,685 23,740 23,167 24,404 23,750 Subtotal, direct Federal investment .......................................................... BA O 160,586 160,131 174,428 169,841 172,020 166,020 188,745 174,316 185,159 178,293 191,500 185,540 194,797 189,653 Total, Federal investment ............................................................................... BA O 238,780 228,007 256,995 243,857 258,860 247,257 276,313 260,670 273,791 264,718 281,222 272,650 285,383 277,803 All other health .......................................................................................... Natural resources and environment .............................................................. National Institute of Standards and Technology .......................................... Hospital and medical care for veterans ........................................................ All other research and development ............................................................. Subtotal, conduct of research and development ..................................... 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING 149 Part II: PLANNING, BUDGETING, AND ACQUISITION OF CAPITAL ASSETS The previous section discussed Federal investment broadly defined. The focus of this section is much narrower—the review of planning and budgeting during the past year and the resultant budget proposals for capital assets owned by the Federal Government and used to deliver Federal services. Capital assets consist of Federal buildings, information technology, and other facilities and major equipment, including weapons systems, federally owned infrastructure, and space satellites.1 With proposed major agency restructuring, organizational streamlining, and other reforms, good planning may suggest reduced spending for some assets, such as office buildings, and increased spending for others, such as information technology, to increase the productivity of a smaller workforce. In recent years the Administration and the Congress have reviewed the Federal Government’s performance in planning, budgeting, risk management, and the acquisition of capital assets. The reviews indicate that the performance is uneven across the Government; the problems have many causes, and as a result, there is no single solution. However, in meeting the objective of improving the Government’s performance, it is essential that the caliber of Government planning and budgeting for capital assets be improved. Improving Planning, Budgeting, and Acquisition of Capital Assets Risk Management.—Recent Executive Branch reviews have found a recurring theme in many capital asset acquisitions—that risk management should become more central to the planning, budgeting, and acquisition process. Failure to analyze and manage the inherent risk in all capital asset acquisitions may have contributed to cost overruns, schedule shortfalls, and acquisitions that fail to perform as expected. Failure to adopt capital asset requirements that are within the capabilities of the market and budget limitations may also have contributed to these problems. For each major project a risk analysis that includes how risks will be isolated, minimized, monitored, and controlled may help prevent these problems. The proposals in this budget, together with recent legislation enacted by Congress, are designed to help the Government manage better its portfolio of capital assets. Long-Term Planning and Analysis.—Planning and managing capital assets, especially better management of risk, has historically been a low priority for some agencies. Attention focuses on coming-year appropriations, and justifications are often limited to lists of desired projects. The increased use of long-range planning linked to performance goals required by the Government Performance and Results Act would provide a 1 This is almost the same as the definition in Part I of this chapter for spending for direct Federal construction and rehabilitation, major equipment, and purchase of land, except that capital assets excludes grants to private groups for these purposes (e.g., grants to universities for research equipment and grants to AMTRAK). A more complete definition can be found in the glossary to the ‘‘Principles of Budgeting for Capital Asset Acquisitions,’’ which is at the end of this Part. better basis for justifications. It would increase foresight and improve the odds for cost-effective investments. A need for better risk management, integrated lifecycle planning, and operation of capital assets at many agencies was evident in the Executive Branch reviews. Research equipment was acquired with inadequate funding for its operation. New medical facilities sometimes were built without funds for maintenance and operation. New information technology sometimes was acquired without planning for associated changes in agency operations. Congressional concern.—Congress has expressed its concern about planning for capital assets with legislation and other actions that complement Administration efforts to ensure better performance: • The Government Performance and Results Act of 1993 (GPRA) is designed to help ensure that program objectives are more clearly defined and resources are focused on meeting these objectives. • The Federal Acquisition Streamlining Act of 1994 (FASA), Title V, requires agencies to improve the management of large acquisitions. Title V requires agencies to institute a performance-based planning, budgeting, and management approach to the acquisition of capital assets. As a result of improved planning efforts, agencies are required to establish cost, schedule, and performance goals that have a high probability of successful achievement. For projects that are not achieving 90 percent of original goals, agencies are required to discuss corrective actions taken or planned to bring the project within goals. If they cannot be brought within goals, agencies should identify how and why the goals should be revised, whether the project is still cost beneficial and justified for continued funding, or whether the project should be canceled. • The Clinger-Cohen Act of 1996 is designed to ensure that information technology acquisitions support agency missions developed pursuant to GPRA. The Clinger-Cohen Act also requires a performance-based planning, budgeting, and management approach to the acquisition of capital assets. • The General Accounting Office published a study, Budget Issues: Budgeting for Federal Capital (November 1996), written in response to a congressional request, which recommended that the Office of Management and Budget (OMB) continue its focus on capital assets. Administration concern.—Since 1994, the Administration has devoted particular attention to improving the process of planning, budgeting, and acquiring capital assets. After seeking out and analyzing the problems, which differed from agency to agency, OMB issued guidance on this issue in 1994. This guidance has been issued for several years, most recently as OMB Circular A–11: Part 3: ‘‘Planning, Budgeting, and Acquisition 150 of Capital Assets’’ (July 1998) (hereafter referred to as Part 3). Part 3 identified other OMB guidance on this issue.2 Part 3 requests agencies to approach planning for capital assets in the context of strategic plans to carry out their missions, and to consider alternative methods of meeting their goals. Systematic analysis of the full life-cycle expected costs and benefits is required, along with risk analysis and assessment of alternative means of acquiring assets. The Administration proposes to make agencies responsible for using good capital programming principles for managing the capital assets they use, and to work throughout the coming year to improve agency practices in risk management, planning, budgeting, acquisition, and operation of these assets. In support of this, in July 1997 OMB issued a Capital Programming Guide. This Guide was developed by an interagency task force with representation from 14 executive agencies and the General Accounting Office. The Guide’s purpose is to provide professionals in the Federal Government a basic reference on capital assets management principles to assist them in planning, budgeting, acquiring, and managing the asset once in use. The Guide emphasizes risk management and the importance of analyzing capital assets as a portfolio. In addition, other recent actions by the Administration include: • OMB memorandum 97–02, ‘‘Funding Information Systems Investments’’ (October 25, 1996) was issued to establish clear and concise decision criteria regarding investments in major information technology investments. • As part of this budget, the Administration is: —requesting full funding in regular or advance appropriations for new capital projects and for many capital projects formerly funded incrementally. These requests are shown in Table 6–5 and discussed in the accompanying text. —reissuing the ‘‘Principles of Budgeting for Capital Asset Acquisitions,’’ which appear at the end of this Part. These principles offer guidelines to agencies to help carry out better planning, analysis, risk management, and budgeting for capital asset acquisitions. From Planning to Budgeting.—Long-range agency plans should channel fully justified budget-year and 2 Other guidance published by OMB with participation by other agencies includes: (1) OMB Circular No. A–109, Major System Acquisitions, which establishes policies for planning major systems that are generally applicable to capital asset acquisitions. (2) OMB Circular No. A–94, Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs, which provides guidance on benefit-cost, cost-effectiveness, and lease-purchase analysis to be used by agencies in evaluating Federal activities including capital asset acquisition. It includes guidelines on the discount rate to use in evaluating future benefits and costs, the measurement of benefits and costs, the treatment of uncertainty, and other issues. This guidance must be followed in all analyses in support of legislative and budget programs. (3) Executive Order No. 12893, ‘‘Principles for Federal Infrastructure Investments,’’ which provides principles for the systematic economic analysis of infrastructure investments and their management. (4) OMB Bulletin No. 94–16, Guidance on Executive Order No. 12893, ‘‘Principles for Federal Infrastructure Investments,’’ which provides guidance for implementing this order and appends the order itself. (5) the revision of OMB Circular A–130, Management of Federal Information Resources (February 20, 1996), which provides principles for internal management and planning practices for information systems and technology; and (6) OMB Circular No. A–127, Financial Management Systems, which prescribes policies and standards for executive departments and agencies to follow in developing, evaluating, and reporting on financial management standards. ANALYTICAL PERSPECTIVES out-year capital acquisition proposals into the budget process. Agencies were asked to submit projections of both budget authority and outlays for high-priority capital asset proposals not only for the budget year but for the four subsequent years through 2004 as well. In addition, agency-specific capital asset issues were highlighted in the agency reviews. Attention was given to whether the ‘‘lumpiness’’ of some capital assets—large one-year temporary increases in funding—disadvantaged them in the budget review process. In some cases, agencies aggregate capital asset acquisitions into budget accounts containing only such acquisitions; such accounts tend to smooth out year-to-year changes in budget authority and outlays and avoid crowding other expenditures. In other cases, agencies or program managers do not hesitate to request ‘‘spikes’’ in spending for asset acquisitions, and the review process accommodates them. But some agencies go out of their way to avoid such spikes, and some agencies have trouble accommodating them. Part 3 encouraged agencies to accommodate justified spikes in their own internal reviews. Full funding of capital assets.—Good budgeting requires that appropriations for the full costs of asset acquisition be provided up front to help ensure that all costs and benefits are fully taken into account when decisions are made about providing resources. Full funding was endorsed by the General Accounting Office in its report, Budgeting for Federal Capital (November 1996). This rule is followed for most Department of Defense procurement and construction programs and for General Services Administration buildings. In other areas, however, too often it is not. When it is not followed and capital assets are funded in increments, without certainty if or when future funding will be available, it can and occasionally does result in poor risk management, weak planning, acquisition of assets not fully justified, higher acquisition costs, cancellation of major projects, the loss of sunk costs, and inadequate funding to maintain and operate the assets. Full funding is also an important element in managing large acquisitions effectively and holding management responsible for achieving goals. This budget requests full funding with regular or advance appropriations for new capital projects and for many capital projects funded incrementally in the past. Projects that might have been funded in increments in past years and are fully funded in this budget are identified below in Table 6–5 and discussed in the accompanying text. Efforts will continue to include full funding for all new capital projects, or at least economically and programmatically viable segments (or modules) of new projects. Other budgeting issues.—Other budgeting decisions can also aid in acquiring capital assets. Availability of funds for one year often may not be enough time to complete the acquisition process. Most agencies request that funds be available for more than one year to complete acquisitions efficiently, and Part 3 encourages this. As noted, many agencies aggregate asset ac- 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING quisition in budget accounts to avoid lumpiness. In some cases, these are revolving funds that ‘‘rent’’ the assets to the agency’s programs. To promote better program performance, agencies are also being encouraged by OMB to examine their budget account structures to align them better with program outputs and outcomes and to charge the appropriate account with significant costs used to achieve these results. The asset acquisition rental accounts, mentioned above, would contribute to this. Budgeting this way would provide information and incentives for better resource allocation among programs and a continual search for better ways to deliver services. It would also provide incentives for efficient capital asset acquisition and management. Acquisition of Capital Assets.—Improved planning, budgeting, and acquisition strategies are necessary to increase the ability of agencies to acquire capital assets within, or close to, the original estimates of cost, schedule, and performance used to justify project budgets and to maintain budget discipline. The Administration initiative along with enactment of FASA (Title V) and the Clinger-Cohen Act require agencies to institute a performance-based planning, budgeting, and management approach to the acquisition of capital assets. OMB, working with the agencies over the last several years, began separate but related efforts to develop an integrated management approach that employs performance based acquisition management as part of a disciplined capital programming process. The Administration also wants the capital asset acquisition goals incorporated into the annual performance plan called for by GPRA so that a unified picture of agency management activities is presented and acquisition performance goals are linked to the achievement of program and policy goals. This integrated approach will not only eliminate duplication in reporting agency actions but, most importantly, will foster more effective implementation of performance-based acquisition management. The first effort was the issuance of OMB Circular A–11, Part 3, ‘‘Planning, Budgeting and Acquisition of Capital Assets,’’ in July 1996. Part 3 has been reissued annually since then. The Capital Programming Guide was issued as a Supplement to Part 3 in June 1997. These documents present unified guidance on planning, budgeting, acquisition, and management of capital assets. It also presents unified guidance designed to coordinate the collection of agency information for reports to the Congress required by FASA Title V. Part 3 for this year asked agencies to report on all major acquisitions and provide information on the extent of planning and risk mitigation efforts accomplished for new projects to ensure a high probability that the cost, schedule and performance goals established will be successfully achieved. For ongoing projects agencies are to provide information on the achievement of, or deviation from, goals. For projects that are not achieving 90 percent of original goals, agencies are required to discuss corrective actions taken, or contemplated, to bring the project within goals. If the project cannot 151 be brought within goals, agencies should explain how and why the goals should be revised and whether the project is still cost beneficial and justifies continued funding, or whether the project should be canceled. Approved acquisition goals submitted with the 2000 budget are the baseline goals for all future monitoring of project progress for both management purposes and reporting to Congress as required by FASA Title V. This more disciplined capital management approach is new to many agencies, and some agencies were not yet able to provide all the required information for all major acquisitions for this year. OMB expects that agencies will be able to meet the requirements for next year’s budget. Part 3 complements OMB memorandum 97–02, ‘‘Funding Information Systems Investments’’ (October 25, 1996), which was issued to establish clear and concise decision criteria regarding investments in major information technology investments. These policy documents establish the general presumption that OMB will recommend new or continued funding only for those major investments in assets that comply with good capital programming principles. At the Appendix to this Part are the ‘‘Principles of Budgeting for Capital Asset Acquisitions,’’ which incorporate the above criteria and expand coverage to all capital investments. The Administration recognizes that many agencies are in the middle of projects initiated prior to enactment of the Clinger-Cohen Act and FASA Title V, and may not be able to satisfy the criteria immediately. For those systems that do not satisfy the criteria, the Administration considered requests to use 1999 and 2000 funds to support reevaluation and replanning of the project as necessary to achieve compliance with the criteria or to determine that the project would not meet the criteria and should be canceled. As a result of these two initiatives, capital asset acquisitions are to have baseline cost, schedule, and performance goals for future tracking purposes or they are to be either reevaluated and changed or canceled if no longer cost beneficial. Outlook.—The effort to improve planning and budgeting for capital assets will continue in 1999 and 2000. • The Administration will work with the Congress to increase the number of projects that are fully funded with regular or advance appropriations. • OMB will be working with congressional committees, the President’s Management Council, the Chief Financial Officers Council, and the Chief Information Officers Council to help agencies with their responsibility for capital assets through the alignment of budgetary resources with program results. OMB will also work with these groups to implement the ‘‘Principles of Budgeting for Capital Asset Acquisitions,’’ which are shown as an Appendix to this Part. • Interagency working groups will be established to address: (1) program manager qualification standards; (2) enhanced systems of incentives to encourage excellence in the acquisition workforce; and 152 ANALYTICAL PERSPECTIVES (3) government-wide implementation of performance-based management systems (e.g., earned value or similar systems) to monitor achievement or deviation from goals of in-process acquisitions. • In the review process, proposals for the acquisition of capital assets and related issues of lumpiness or ‘‘spikes’’ will continue to receive special attention. Agencies will be encouraged to give the same special attention to future asset acquisition proposals. • To ensure that the full costs and benefits of all budget proposals are fully taken into account in allocating resources, agencies will be required to propose full funding for acquisitions in their budget requests. Major Acquisition Proposals For the definition of major capital assets described above this budget requests $73.4 billion of budget authority for 2000. This includes $54.1 billion for the Department of Defense and $19.3 billion for other agencies. The major requests are shown in the accompanying Table 6–4: ‘‘Capital Asset Acquisitions,’’ which distributes the funds according to the categories for construction and rehabilitation, major equipment, and purchases of land and structures. Table 6–4. CAPITAL ASSET ACQUISITIONS (Budget authority in billions of dollars) 1998 actual MAJOR ACQUISITIONS Construction and rehabilitation: Defense military construction and family housing ....... Army Corps of Engineers ............................................. Department of Energy ................................................. Department of Veterans Affairs ................................... General Services Administration ................................. Other agencies ............................................................. 1999 proposed 2000 proposed 4.2 2.1 1.1 1.0 0.4 5.8 4.0 2.6 1.1 1.0 1.2 6.6 1.6 2.6 1.1 0.8 0.8 5.9 Subtotal, construction and rehabilitation .................. Major equipment: Department of Defense ................................................. Department of Transportation ....................................... NASA ............................................................................. Department of Veterans Affairs .................................... Department of the Treasury ........................................ Other agencies ............................................................. 14.5 16.5 12.9 44.9 2.1 0.7 0.7 0.9 3.0 48.6 2.5 0.7 0.7 0.9 3.4 52.5 2.5 0.6 0.5 0.4 3.7 Subtotal, major equipment ........................................ Purchases of land and structures ..................................... 52.4 1.2 56.7 0.6 60.1 0.7 Total, major acquisitions 1 ............................................. Sale of major assets ......................................................... 68.1 –5.2 73.9 ........... 73.7 –0.3 Total, capital asset acquisitions 1/ .................................... 62.9 73.9 73.4 1 This total is derived from the direct Federal major public physical investment budget authority on Table 6–3 ($75.7 billion for 2000). Table 6–4 excludes an estimate of spending for assets not owned by the Federal Government ($2.3 billion for 2000). Construction and Rehabilitation This budget includes $12.9 billion of budget authority for 2000 for construction and rehabilitation. Department of Defense.—The budget requests $1.6 billion for 2000 for general construction on military bases and family housing. This funding will be used to: • support the fielding of new systems; • enhance operational readiness, including deployment and support of military forces; • provide housing for military personnel and their families; • implement base closure and realignment actions; and • correct safety deficiencies and environmental problems. Army Corps of Engineers.—This budget requests $2.6 billion for 2000 for construction and rehabilitation for the Army Corps of Engineers. These funds finance construction, rehabilitation, and related activity for water resources development projects that provide navigation, flood control, environmental restoration, and other benefits. Department of Energy.—This budget requests $1.1 billion for 2000 for construction and rehabilitation for the Department of Energy. The largest item is for the National Ignition Facility, which will be used to perform experiments, including inertial confinement fusion experiments, at high pressures and temperatures. Some of these investments are also discussed in the text that accompanies Table 6–5. Department of Veterans Affairs.—The budget requests $0.8 billion for construction and rehabilitation associated with veterans hospitals. These funds will provide for modernization and improvements to these facilities. General Services Administration (GSA).—The 2000 budget includes $0.8 billion in budget authority for GSA for the construction or renovation of buildings. These funds will allow for new construction and the acquisition of border stations and general purpose office space in locations where long-term needs show that ownership is preferable to leasing. Other agencies.—This budget includes $5.9 billion for construction and rehabilitation for other agencies in 2000. The largest items are for the Postal Service ($1.5 billion), the Department of the Interior ($0.8 billion), and the Tennessee Valley Authority ($0.7 billion). Major Equipment This category covers capital purchases for major equipment, including weapons systems; information technology, such as computer hardware, major software, and renovations required for this equipment; and other types of equipment. This budget requests $60.1 billion in budget authority for 2000 for the purchase of major equipment. Department of Defense.—The budget requests $52.5 billion for 2000 to procure or modify weapons systems, related support equipment, and purchase of other capital goods. This includes tactical fighter aircraft, airlift aircraft, naval vessels, tanks, helicopters, missiles, and vehicles. Department of Transportation.—The budget requests $2.5 billion in budget authority for the Department of Transportation, which includes $2.3 billion to modern- 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING ize the air traffic control system and $0.2 billion for the Coast Guard to acquire vessels and other equipment. Requests for advance appropriations for the air traffic control system in the Federal Aviation Administration are discussed with Table 6–5. National Aeronautics and Space Administration (NASA).—The budget requests $0.6 billion in budget authority to procure major equipment for programs in human space flight, science, aeronautics, and technology. Most of the equipment is to be acquired for Space Shuttle upgrades, such as orbiter improvements, Space Shuttle main engines, solid rocket booster improvements, and launch site equipment. Department of Veterans Affairs.—This budget requests $0.5 billion for medical equipment for health care facilities for veterans. These funds will be used to continue to provide quality health care services for veterans. Department of the Treasury.—The budget requests $0.4 billion in budget authority for 2000 for major equipment. These resources fund Internal Revenue Service information systems and other Treasury investment needs. The IRS funding and advanced appropriations ($325 million) for 2001 for the IRS information technology investment account will help the IRS improve customer service by providing alternative means of filing returns and paying taxes, improve telephone service for taxpayers; and give employees immediate access to complete information and modern tools to do their jobs. Advanced appropriations ($163 million) for the U.S. Customs Service in 2001 will fund modernization of automated commercial operations and an international trade data system. These investments are also discussed in the text that accompanies Table 6–5, which displays advance appropriations for capital acquisitions. Other agencies.—This budget requests $3.7 billion for major equipment for other agencies for 2000. The largest amount is for the Postal Service ($0.8 billion). Other agencies include the General Services Administration ($0.7 billion); the Department of Energy ($0.6 billion) for science and other projects; and the Department of Commerce ($0.6 billion), for procurement of weather satellites and other equipment. Purchase and Sale of Land and Structures This budget includes $0.7 billion for 2000 for the purchase of land and structures. This includes $0.2 billion for the purchase of buildings by the General Services Administration. The sale of assets that took place in 1998 was for proceeds from the sale of the United States Enrichment Corporation ($1.9 billion), the privatization of Elk Hills ($2.9 billion), and other assets. Full Funding of Major Projects This budget proposes full funding for new capital projects and for many projects formerly funded incrementally. The requests for advance appropriations shown in Table 6–5 demonstrate the Admninistration’s continuing support for full funding of capital investments. 153 The importance of full funding was discussed earlier in this Part and is also explained in the ‘‘Principles of Budgeting for Capital Asset Acquisitions,’’ which appears as an Appendix to this Part. This budget requests $5.5 billion in budget authority for 2000 and $24.6 billion in advance appropriations for later years, for a total request of $30.1 billion for these projects for these years. Department of Commerce National Oceanic and Atmospheric Administration (NOAA).—This budget requests $563 million for 2000 and $5,367 million in advance appropriations for capital asset acquisitions in NOAA for 2001–2018. These acquisitions support the largest modernization in the history of the National Weather Service. The modernization is well underway and demonstrating improvements in weather forecasts and warnings that lead to lives and property saved. The budget supports this multi-year effort to develop and deploy advanced technology, including advanced radar equipment, other ground observing systems, and geostationary and polarorbiting satellites that will greatly improve the timeliness and accuracy of severe weather and flood warnings while reducing staffing requirements. National Telecommunications and Information Administrations—The budget requests $35 million in 2000 and $314 million in advance appropriations for 2001–2004 to support the acquisition of digital technology for public television. Department of Defense This budget requests $2,484 million in advance appropriations for 2001 to fully fund selected military construction and family housing projects in the Department of Defense. The budget requests $1,631 million for these projects in 2000. Department of Energy Defense environmental management privatization.— The budget requests $228 million in 2000 to proceed with various projects that will treat some of DOE’s most contaminated soil and highly radioactive waste. An additional $2,557 million in advance appropriations for 2001–2004 is requested to provide primarily for treatment of high-level radioactive waste stored in underground tanks at the Hanford nuclear facility in Washington. This waste will be stabilized for safe storage and eventual disposal. Clean coal technology.—The clean coal technology program supports cost-shared projects with industry to demonstrate the technical and economic viability of environmentally friendly and efficient technologies to extract energy from coal. Advanced appropriations for the clean coal technology program were provided by Congress in 1984 and 1988. The budget defers the availability of $256 million of the clean coal technology program balances in 2000 and requests an advance appropriation to recoup the deferred budget authority in 2001–2003. Delays in the construction of two large 154 ANALYTICAL PERSPECTIVES Table 6–5. PROPOSED SPENDING TO FULLY FUND SELECTED CAPITAL ASSET ACQUISITIONS (Budget authority in millions of dollars) Advance appropriations Regular appropriations 2000 2001 2002 2003 2004 After 2004 Total Advance Appropriations DEPARTMENT OF COMMERCE National Oceanic and Atmospheric Administration: Procurement, acquisition and construction .................. National Telecommunications and Information Administration:. Public telecommunications facilities, planning and construction ....................................................................... 563 611 587 587 655 2,927 5,367 35 110 100 89 15 ............ 314 Subtotal, Department of Commerce .............................................................................................................. 598 721 687 676 670 2,927 5,681 DEPARTMENT OF DEFENSE Military construction and family housing .......................................................................................................... 1,631 2,484 ............ ............ ............ ............ 2,484 DEPARTMENT OF ENERGY Defense environmental management privatization 1/ ............................................................................................ Clean coal technology ............................................................................................................................................. 228 –256 671 189 659 40 633 27 594 ............ ............ ............ 2,557 256 Subtotal, Department of Energy. ........................................................................................................................ –28 860 699 660 594 ............ 2,813 DEPARTMENT OF HEALTH AND HUMAN SERVICES Indian health facilities. ............................................................................................................................................. 36 34 10 ............ ............ ............ 44 DEPARTMENT OF THE INTERIOR National Park Service: Construction and major maintenance ............................................................................ 26 57 16 15 10 ............ 98 DEPARTMENT OF STATE Security and maintenance of United States missions ..................................................................................... 36 300 450 600 750 900 3,000 DEPARTMENT OF TRANSPORTATION Federal Aviation Administration: Facilities and equipment ............................................................................... 596 739 439 355 191 258 1,982 DEPARTMENT OF THE TREASURY Internal Revenue Service: Information technology investment ........................................................................... United States Customs Service: Automation modernization ............................................................................. ............ ............ 325 163 ............ ............ ............ ............ ............ ............ ............ ............ 325 163 Subtotal, Department of the Treasury ............................................................................................................... ............ 488 ............ ............ ............ ............ 488 GENERAL SERVICES ADMINISTRATION Federal buildings fund ............................................................................................................................................. 41 163 ............ ............ ............ ............ 163 NATIONAL AERONAUTICS AND SPACE ADMINISTRATION Human space flight ................................................................................................................................................. 2,483 2,328 2,091 1,721 1,573 ............ 7,713 NATIONAL SCIENCE FOUNDATION Major research equipment ...................................................................................................................................... 29 58 41 15 17 ............ 131 SMITHSONIAN INSTITUTION Construction ............................................................................................................................................................. 8 17 17 18 ............ ............ 52 Total .................................................................................................................................................................... 5,456 8,249 4,450 4,060 3,805 4,085 24,649 Note: For these capital projects, budget authority for the project is requested partly in the budget year and partly in future years in advance appropriations. 1 Additional funding for this program will be needed in future years. clean coal technology demonstration projects make the deferral possible. Department of Health and Human Services This budget requests $36 million for 2000 in regular appropriations and $44 million in advance appropriations for projects in the Department of Health and Human Services for Indian health facilities. The funds will allow for needed improvements in these facilities. Department of the Interior National Park Service.—This budget requests $26 million in budget authority for 2000 and $98 million in advance appropriations for 2001–2004 to fully fund projects in the National Park Service. The National Park Service needs to build or restore its buildings and other structures over the next few years. Funding stability is particularly needed for the National Park Service (NPS) to restore the Elwha River in Olympic National Park, Washington, by acquiring and removing two dams. Before the NPS can acquire the dams, the Secretary of the Interior must determine that funds to complete restoration are available. In addition to $30 million already appropriated for acquisition and $12 million in 2000, advance appropriations of $71 million in 2001 through 2004 would fully fund the $113 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING million project and provide the funding stability needed for the Secretary to proceed with acquisition. Advance appropriations in 2001 totaling $27 million are also requested for seven parks that have an ongoing project requiring funding for later years: Sequoia National Park, Gettysburg National Military Park, Cape Cod National Seashore, Statue of Liberty/Ellis Island, San Francisco Maritime National Historical Park, George Washington Parkway/Glen Echo, and Cumberland Island National Seashore. 155 the Federal government by reducing redundant data requests and processing. General Services Administration This budget requests $41 million for 2000 and $163 million in advance appropriations for 2001 for the construction of a new Bureau of Alcohol, Tobacco and Firearms headquarters and office space for the Food and Drug Administration’s Center for Drug and Evaluation Research. Department of State This budget requests $36 million for 2000 and advance appropriations of $3.0 billion for 2001–2005 for embassy and consulate construction. This request would establish a program to provide a sustained, increasing funding path to meet overseas facility security needs. Department of Transportation Federal Aviation Administration.—This budget requests $596 million in 2000 and an additional $1,982 million for 2001–2007 for 11 multi-year capital projects to improve and modernize the FAA’s air traffic control, communications, and aviation weather information systems. These projects are: Aviation Weather Services Improvements, Terminal Digital Radar, Terminal Automation (STARS), Wide Area Augmentation System for GPS, Display System Replacement, Weather and Radar Processor, Voice Switching and Control System, Oceanic Automation, Aeronautical Data Link, Operational and Supportability Implementation System (OASIS), and Beacon Interrogation Replacement. Department of the Treasury Internal Revenue Service (IRS).—This budget requests $325 million in advance appropriations for 2001 to finance information technology investments. Budget authority enacted in 1998 and 1999 will finance the program through 2000. The IRS and the Treasury Department are significantly modifying the business plans for modernizing the IRS tax administration and systems by focusing on reengineering work processes and exploring private sector technology opportunities. These efforts will ensure that future capital investments by the IRS will improve customer service by providing alternative means of filing returns and paying taxes, improve telephone service for taxpayers; and give employees immediate access to complete information and modern tools to do their jobs. United States Customs Service.—This budget requests $163 million advance appropriations for 2001 to finance modernization of automated commercial operations and an international trade data system. The Customs Service must modernize its existing automated systems in order to keep up with the increasing volume of trade and to proceed with its recently redesigned trade process, which will deal with importers on an account level rather than on a transaction by transaction basis. In addition, an international trade data system will further simplify the trade community’s interactions with National Aeronautics and Space Administration (NASA) Human Space Flight (International Space Station).— This budget requests $2,483 million in budget authority for 2000, and $7,713 million in advance appropriations over the years 2001–2004 for the space station. This will be an international laboratory in low earth orbit on which American, Russian, Canadian, European, and Japanese astronauts will conduct unique scientific and technological investigations in a microgravity environment. During 1993 the program underwent a major redesign to reduce program costs. The first two launches beginning construction of the Station took place in 1998 and final assembly will be complete by 2004. Advance appropriations will enable NASA to complete the development program on schedule and at minimal total cost. Since the redesign, Congress has appropriated $13.5 billion through 1999. National Science Foundation (NSF) This budget requests $29 million in 2000 and $131 million in advance appropriations for 2001–2004 to complete the redevelopment of the U.S. station at the South Pole in Antarctica, NSF’s contribution to the International Large Hadron Collider, and the Network for Earthquake Engineering Simulation. These amounts include $5 million in 2000 and $14 million in 2001 to complete the redevelopment of the South Pole station. This will provide a platform for scientific activities, provide a safe working and living environment, and maintain a U.S. presence in the Antarctica in accordance with national policy. The Large Hadron Collider will be the largest particle accelerator in the world, and will be owned and operated by the European Laboratory for Particle Physics (CERN). NSF is collaborating with the Department of Energy in the development of detectors for the project. The budget requests $16 million in 2000 and $43 million in 2001–2003 to complete NSF’s contribution. The Newtwork for Earthquake Engineering Simulation is a network to connect and integrate a distributed collection of earthquake engineering facilities that will facilitate the future replacement of mechanical earthquake simulation with model-based computer simulation. The budget requests $8 million in 2000 and $74 million for 2001–2004 to complete development of the network. 156 ANALYTICAL PERSPECTIVES Smithsonian Institution The budget requests $8 million in budget authority in 2000 and $52 million in advance appropriations for 2001–2003 for the major capital renewal of the Patent Office Building. This building houses the Smithsonian’s Museum of American Art and the National Portrait Gallery. Appendix to Part II: PRINCIPLES OF BUDGETING FOR CAPITAL ASSET ACQUISITIONS Introduction and Summary The Administration plans to use the following principles in budgeting for capital asset acquisitions. These principles address planning, costs and benefits, financing, and risk management requirements that should be satisfied before a proposal for the acquisition of capital assets can be included in the Administration’s budget. A Glossary describes key terms. A Capital Programming Guide has been published that provides detailed information on planning and acquisition of capital assets. The principles are organized in the following four sections: A. Planning. This section focuses on the need to ensure that capital assets support core/priority missions of the agency; the assets have demonstrated a projected return on investment that is clearly equal to or better than alternative uses of available public resources; the risk associated with the assets is understood and managed at all stages; and the acquisition is implemented in phased, successive segments, unless it can be demonstrated there are significant economies of scale at acceptable risk from funding more than one segment or there are multiple units that need to be acquired at the same time. B. Costs and Benefits. This section emphasizes that the asset should be justified primarily by benefit-cost analysis, including life-cycle costs; that all costs are understood in advance; and that cost, schedule, and performance goals are identified that can be measured using an earned value management system or similar system. C. Principles of Financing. This section stresses that useful segments are to be fully funded with regular or advance appropriations; that as a general rule, planning segments should be financed separately from procurement of the asset; and that agencies are encouraged to aggregate assets in capital acquisition accounts and take other steps to accommodate lumpiness or ‘‘spikes’’ in funding for justified acquisitions. D. Risk Management. This section is to help ensure that risk is analyzed and managed carefully in the acquisition of the asset. Strategies can include separate accounts for capital asset acquisitions, the use of apportionment to encourage sound management, and the selection of efficient types of contracts and pricing mechanisms in order to allocate risk appropriately between the contractor and the Government. In addition cost, schedule, and performance goals are to be controlled and monitored by using an earned value management system or a similar system; and if progress toward these goals is not met there is a formal review process to evaluate whether the acquisition should continue or be terminated. A Glossary defines key terms, including capital assets. As defined here, capital assets are land, structures, equipment, and intellectual property (including software) that are used by the Federal Government, including weapon systems. Not included are grants to States or others for their acquisition of capital assets. A. Planning Investments in major capital assets proposed for funding in the Administration’s budget should: 1. support core/priority mission functions that need to be performed by the Federal Government; 2. be undertaken by the requesting agency because no alternative private sector or governmental source can support the function more efficiently; 3. support work processes that have been simplified or otherwise redesigned to reduce costs, improve effectiveness, and make maximum use of commercial, off-the-shelf technology; 4. demonstrate a projected return on the investment that is clearly equal to or better than alternative uses of available public resources. Return may include: improved mission performance in accordance with measures developed pursuant to the Government Performance and Results Act; reduced cost; increased quality, speed, or flexibility; and increased customer and employee satisfaction. Return should be adjusted for such risk factors as the project’s technical complexity, the agency’s management capacity, the likelihood of cost overruns, and the consequences of under- or non-performance; 5. for information technology investments, be consistent with Federal, agency, and bureau information architectures which: integrate agency work processes and information flows with technology to achieve the agency’s strategic goals; reflect the agency’s technology vision and year 2000 compliance plan; and specify standards that enable information exchange and resource sharing, while retaining flexibility in the choice of suppliers and in the design of local work processes; 6. reduce risk by: avoiding or isolating custom-designed components to minimize the potential adverse consequences on the overall project; using fully tested pilots, simulations, or prototype implementations when necessary before going to production; establishing clear measures and accountability for project progress; and, securing substantial involvement and buy-in throughout the project 6. 157 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING from the program officials who will use the system; 7. be implemented in phased, successive segments as narrow in scope and brief in duration as practicable, each of which solves a specific part of an overall mission problem and delivers a measurable net benefit independent of future segments, unless it can be demonstrated that there are significant economies of scale at acceptable risk from funding more than one segment or there are multiple units that need to be acquired at the same time; and 8. employ an acquisition strategy that appropriately allocates risk between the Government and the contractor, effectively uses competition, ties contract payments to accomplishments, and takes maximum advantage of commercial technology. Prototypes require the same justification as other capital assets. As a general presumption, the Administration will recommend new or continued funding only for those capital asset investments that satisfy good capital programming policies. Funding for those projects will be recommended on a phased basis by segment, unless it can be demonstrated that there are significant economies of scale at acceptable risk from funding more than one segment or there are multiple units that need to be acquired at the same time. (For more information, see the Glossary entry, ‘‘capital project and useful segments of a capital project.’’) The Administration recognizes that many agencies are in the middle of ongoing projects, and they may not be able immediately to satisfy the criteria. For those projects that do not satisfy the criteria, OMB will consider requests to use 1999 and 2000 funds to finance additional planning, as necessary, to support the establishment of realistic cost, schedule, and performance goals for the completion of the project. This planning could include: the redesign of work processes, the evaluation of alternative solutions, the development of information system architectures, and, if necessary, the purchase and evaluation of prototypes. Realistic goals are necessary for agency portfolio analysis to determine the viability of the project, to provide the basis for fully funding the project to completion, and setting the baseline for management accountability to deliver the project within goals. Because the Administration considers this information essential to agencies’ long-term success, the Administration will use this information both in preparing its budget and, in conjunction with cost, schedule, and performance data, as apportionments are made. Agencies are encouraged to work with their OMB representative to arrive at a mutually satisfactory process, format, and timetable for providing the requested information. B. Costs and Benefits The justification of the project should evaluate and discuss the extent to which the project meets the above criteria and should also include: 1. an analysis of the project’s total life-cycle costs and benefits, including the total budget authority required for the asset, consistent with policies described in OMB Circular A–94: ‘‘Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs’’ (October 1992); 2. an analysis of the risk of the project including how risks will be isolated, minimized, monitored, and controlled, and, for major programs, an evaluation and estimate by the Chief Financial Officer of the probability of achieving the proposed goals; 3. if, after the planning phase, the procurement is proposed for funding in segments, an analysis showing that the proposed segment is economically and programmatically justified—that is, it is programmatically useful if no further investments are funded, and in this application its benefits exceed its costs; and 4. show cost, schedule, and performance goals for the project (or the useful segment being proposed) that can be measured throughout the acquisition process using an earned value management system or similar system. Earned value is described in OMB Circular A–11, Part 3, ‘‘Planning, Budgeting and Acquisition of Capital Assets,’’ (July 1998), Appendix 300C. C. Principles of Financing Principle 1: Full Funding Budget authority sufficient to complete a useful segment of a capital project (or the entire capital project, if it is not divisible into useful segments) must be appropriated before any obligations for the useful segment (or project) may be incurred. Explanation: Good budgeting requires that appropriations for the full costs of asset acquisition be enacted in advance to help ensure that all costs and benefits are fully taken into account at the time decisions are made to provide resources. Full funding with regular appropriations in the budget year also leads to tradeoffs within the budget year with spending for other capital assets and with spending for purposes other than capital assets. Full funding increases the opportunity to use performance-based fixed price contracts, allows for more efficient work planning and management of the capital project, and increases the accountability for the achievement of the baseline goals. When full funding is not followed and capital projects or useful segments are funded in increments, without certainty if or when future funding will be available, the result is sometimes poor planning, acquisition of assets not fully justified, higher acquisition costs, cancellation of major projects, the loss of sunk costs, or inadequate funding to maintain and operate the assets. Principle 2: Regular and Advance Appropriations Regular appropriations for the full funding of a capital project or a useful segment of a capital project in the budget year are preferred. If this results in spikes 158 that, in the judgment of OMB, cannot be accommodated by the agency or the Congress, a combination of regular and advance appropriations that together provide full funding for a capital project or a useful segment should be proposed in the budget. Explanation: Principle 1 (Full Funding) is met as long as a combination of regular and advance appropriations provide budget authority sufficient to complete the capital project or useful segment. Full funding in the budget year with regular appropriations alone is preferred because it leads to tradeoffs within the budget year with spending for other capital assets and with spending for purposes other than capital assets. In contrast, full funding for a capital project over several years with regular appropriations for the first year and advance appropriations for subsequent years may bias tradeoffs in the budget year in favor of the proposed asset because with advance appropriations the full cost of the asset is not included in the budget year. Advance appropriations, because they are scored in the year they become available for obligation, may constrain the budget authority and outlays available for regular appropriations of that year. If, however, the lumpiness caused by regular appropriations cannot be accommodated within an agency or Appropriations Subcommittee, advance appropriations can ameliorate that problem while still providing that all of the budget authority is enacted in advance for the capital project or useful segment. The latter helps ensure that agencies develop appropriate plans and budgets and that all costs and benefits are identified prior to providing resources. In addition, amounts of advance appropriations can be matched to funding requirements for completing natural components of the useful segment. Advance appropriations have the same benefits as regular appropriations for improved planning, management, and accountability of the project. Principle 3: Separate Funding of Planning Segments As a general rule, planning segments of a capital project should be financed separately from the procurement of a useful asset. Explanation: The agency must have information that allows it to plan the capital project, develop the design, and assess the benefits, costs, and risks before proceeding to procurement of the useful asset. This is especially important for high risk acquisitions. This information comes from activities, or planning segments, that include but are not limited to market research of available solutions, architectural drawings, geological studies, engineering and design studies, and prototypes. The construction of a prototype that is a capital asset, because of its cost and risk, should be justified and planned as carefully as the project itself. The process of gathering information for a capital project may consist of one or more planning segments, depending on the nature of the asset. Funding these segments separately will help ensure that the necessary information ANALYTICAL PERSPECTIVES is available to establish cost, schedule, and performance goals before proceeding to procurement. If budget authority for planning segments and procurement of the useful asset are enacted together, the Administration may wish to apportion budget authority for one or several planning segments separately from procurement of the useful asset. Principle 4: Accommodation of Lumpiness or ‘‘Spikes’’ and Separate Capital Acquisition Accounts To accommodate lumpiness or ‘‘spikes’’ in funding justified capital acquisitions, agencies, working with OMB, are encouraged to aggregate financing for capital asset acquisitions in one or several separate capital acquisition budget accounts within the agency, to the extent possible within the agency’s total budget request. Explanation: Large, temporary, year-to-year increases in budget authority, sometimes called lumps or spikes, may create a bias against the acquisition of justified capital assets. Agencies, working with OMB, should seek ways to avoid this bias and accommodate such spikes for justified acquisitions. Aggregation of capital acquisitions in separate accounts may: • reduce spikes within an agency or bureau by providing roughly the same level of spending for acquisitions each year; • help to identify the source of spikes and to explain them. Capital acquisitions are more lumpy than operating expenses; and with a capital acquisition account, it can be seen that an increase in operating expenses is not being hidden and attributed to one-time asset purchases; • reduce the pressure for capital spikes to crowd out operating expenses; and • improve justification and make proposals easier to evaluate, since capital acquisitions are generally analyzed in a different manner than operating expenses (e.g., capital acquisitions have a longer time horizon of benefits and life-cycle costs). D. Risk Management Risk management should be central to the planning, budgeting, and acquisition process. Failure to analyze and manage the inherent risk in all capital asset acquisitions may contribute to cost overruns, schedule shortfalls, and acquisitions that fail to perform as expected. For each major capital project a risk analysis that includes how risks will be isolated, minimized, monitored, and controlled may help prevent these problems. The project cost, schedule and performance goals established through the planning phase of the project are the basis for approval to procure the asset and the basis for assessing risk. During the procurement phase performance-based management systems (earned value or similar system) must be used to provide contractor and Government management visibility on the achievement of, or deviation from, goals until the asset is accepted and operational. If goals are not being met, 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING performance-based management systems allow for early identification of problems, potential corrective actions, and changes to the original goals needed to complete the project and necessary for agency portfolio analysis decisions. These systems also allow for Administration decisions to recommend meaningful modifications for increased funding to the Congress, or termination of the project, based on its revised expected return on investment in comparison to alternative uses of the funds. Agencies must ensure that the necessary acquisition strategies are implemented to reduce the risk of cost escalation and the risk of failure to achieve schedule and performance goals. These strategies may include: 1. having budget authority appropriated in separate capital asset acquisition accounts; 2. apportioning budget authority for a useful segment; 3. establishing thresholds for cost, schedule, and performance goals of the acquisition, including return on investment, which if not met may result in cancellation of the acquisition; 4. selecting types of contracts and pricing mechanisms that are efficient and that provide incentives to contractors in order to allocate risk appropriately between the contractor and the Government; 5. monitoring cost, schedule, and performance goals for the project (or the useful segment being proposed) using an earned value management system or similar system. Earned value is described in OMB Circular A–11, Part 3, ‘‘Planning, Budgeting and Acquisition of Capital Assets’’ (July 1998), Appendix 300C; and 6. if progress is not within 90 percent of goals, or if new information is available that would indicate a greater return on investment from alternative uses of funds, institute senior management review of the project through portfolio analysis to determine the continued viability of the project with modifications, or the termination of the project, and the start of exploration for alternative solutions if it is necessary to fill a gap in agency strategic goals and objectives. E. Glossary Appropriations An appropriation provides budget authority that permits Government officials to incur obligations that result in immediate or future outlays of Government funds. Regular annual appropriations: These appropriations are: • enacted normally in the current year; • scored entirely in the budget year; and • available for obligation in the budget year and subsequent years if specified in the language. (See ‘‘Availability,’’ below.) Advance appropriations: Advance appropriations may be accompanied by regular annual appropriations to 159 provide funds available for obligation in the budget year as well as subsequent years. Advance appropriations are: • enacted normally in the current year; • scored after the budget year (e.g., in each of one, two, or more later years, depending on the language); and • available for obligation in the year scored and subsequent years if specified in the language. (See ‘‘Availability,’’ below.) Availability: Appropriations made in appropriations acts are available for obligation only in the budget year unless the language specifies that an appropriation is available for a longer period. If the language specifies that the funds are to remain available until the end of a certain year beyond the budget year, the availability is said to be ‘‘multi-year.’’ If the language specifies that the funds are to remain available until expended, the availability is said to be ‘‘no-year.’’ Appropriations for major procurements and construction projects are typically made available for multiple years or until expended. Capital Assets Capital assets are land, structures, equipment, and intellectual property (including software) that are used by the Federal Government and have an estimated useful life of two years or more. Capital assets exclude items acquired for resale in the ordinary course of operations or held for the purpose of physical consumption such as operating materials and supplies. The cost of a capital asset includes both its purchase price and all other costs incurred to bring it to a form and location suitable for its intended use. Capital assets may be acquired in different ways: through purchase, construction, or manufacture; through a lease-purchase or other capital lease, regardless of whether title has passed to the Federal Government; through an operating lease for an asset with an estimated useful life of two years or more; or through exchange. Capital assets include leasehold improvements and land rights; assets owned by the Federal Government but located in a foreign country or held by others (such as Federal contractors, state and local governments, or colleges and universities); and assets whose ownership is shared by the Federal Government with other entities. Capital assets include not only the assets as initially acquired but also additions; improvements; replacements; rearrangements and reinstallations; and major repairs but not ordinary repairs and maintenance. Examples of capital assets include the following, but are not limited to them: office buildings, hospitals, laboratories, schools, and prisons; dams, power plants, and water resources projects; furniture, elevators, and printing presses; motor vehicles, airplanes, and ships; satellites and space exploration equipment; information technology hardware and software; and Department of Defense weapons systems. Capital assets may or may not be capitalized (i.e., recorded in an entity’s balance 160 ANALYTICAL PERSPECTIVES sheet) under Federal accounting standards. Examples of capital assets not capitalized are Department of Defense weapons systems, heritage assets, stewardship land, and some software. Capital assets do not include grants for acquiring capital assets made to State and local governments or other entities (such as National Science Foundation grants to universities or Department of Transportation grants to AMTRAK). Capital assets also do not include intangible assets such as the knowledge resulting from research and development or the human capital resulting from education and training, although capital assets do include land, structures, equipment, and intellectual property (including software) that the Federal Government uses in research and development and education and training. Illustration 2: If the full acquisition is for several items (e.g., aircraft), the useful segment would be the number of complete aircraft required to achieve benefits that exceed costs even if no further funding becomes available. In contrast, some portion of several aircraft (e.g., engines for five aircraft) would not be a useful segment if no further funding is available, nor would one aircraft be a useful segment if two or more are required for benefits to exceed costs. Illustration 3: For information technology, a module (the information technology equivalent of ‘‘useful segment’’) is separable if it is useful in itself without subsequent modules. The module should be designed so that it can be enhanced or integrated with subsequent modules if future funding becomes available. Capital Project and Useful Segments of a Capital Project Earned Value Earned value refers to a performance-based management system for establishing baseline cost, schedule, and performance goals for a capital project and measuring progress against the goals. Earned value is described in OMB Circular A–11, Part 3, ‘‘Planning, Budgeting and Acquisition of Capital Assets’’ (July 1998), Appendix 300C. The total capital project, or acquisition of a capital asset, includes useful segments that are either planning segments or useful assets. Planning segments: A planning segment of a capital project provides information that allows the agency to develop the design; assess the benefits, costs, and risks; and establish realistic baseline cost, schedule, and performance goals before proceeding to full acquisition of the useful asset (or canceling the acquisition). This information comes from activities, or planning segments, that include but are not limited to market research of available solutions, architectural drawings, geological studies, engineering and design studies, and prototypes. The process of gathering information for a capital project may consist of one or more planning segments, depending on the nature of the asset. If the project includes a prototype that is a capital asset, the prototype may itself be one segment or may be divisible into more than one segment. Because of uncertainty regarding the identification of separate planning segments for research and development activities, the application of full funding concepts to research and development planning will need more study. Useful asset: A useful asset is an economically and programmatically separate segment of the asset procurement stage of the capital project that provides an asset for which the benefits exceed the costs, even if no further funding is appropriated. The total capital asset procurement may include one or more useful assets, although it may not be possible to divide all procurements in this way. Illustrations follow: Illustration 1: If the construction of a building meets the justification criteria and has benefits greater than its costs without further investment, then the construction of that building is a ‘‘useful segment.’’ Excavation is not a useful segment because no useful asset results from the excavation alone if no further funding becomes available. For a campus of several buildings, a useful segment is one complete building if that building has programmatic benefits that exceed its costs regardless of whether the other buildings are constructed, even though that building may not be at its maximum use. Funding Full funding: Full funding means that appropriations—regular appropriations or advance appropriations—are enacted that are sufficient in total to complete a useful segment of a capital project before any obligations may be incurred for that segment. Full funding for an entire capital project is required if the project cannot be divided into more than one useful segment. If the asset can be divided into more than one useful segment, full funding for a project may be desirable, but is not required to constitute full funding. Incremental (partial) funding: Incremental (partial) funding means that appropriations—regular appropriations or advance appropriations—are enacted for just part of a useful segment of a capital project, if the project has useful segments, or for part of the capital project as a whole, if it is not divisible into useful segments. Under incremental funding for a capital asset, which is not permitted under these principles, the funds could be obligated to start the segment (or project) despite the fact that they are insufficient to complete a useful segment or project. Risk Management Risk management is an organized method of identifying and measuring risk and developing, selecting, and managing options for handling these risks. Before beginning any procurement, managers should review and revise as needed the acquisition plan to ensure that risk management techniques considered in the planning phase are still appropriate. There are three key principles for managing risk when procuring capital assets: (1) avoiding or limiting the amount of development work; (2) making effective use of competition and financial incentives; and (3) es- 6. 161 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING tablishing a performance-based acquisition management system that provides for accountability for program successes and failures, such as an earned value system or similar system. There are several types of risk an agency should consider as part of risk management. The types of risk include: • schedule risk; • • • • cost risk; technical feasibility; risk of technical obsolescence; dependencies between a new project and other projects or systems (e.g., closed architectures); and • risk of creating a monopoly for future procurement. Part III: FEDERALLY FINANCED CAPITAL STOCKS Federal investment spending creates a ‘‘stock’’ of capital that is available in the future for productive use. Each year, Federal investment outlays add to the stock of capital. At the same time, however, wear and tear and obsolescence reduce it. This section presents very rough measures over time of three different kinds of capital stocks financed by the Federal Government: public physical capital, research and development (R&D), and education. Federal spending for physical assets adds to the Nation’s capital stock of tangible assets, such as roads, buildings, and aircraft carriers. These assets deliver a flow of services over their lifetime. The capital depreciates as the asset ages, wears out, is accidentally damaged, or becomes obsolete. Federal spending for the conduct of research, development, and education adds to an ‘‘intangible’’ asset, the Nation’s stock of knowledge. Although financed by the Federal Government, the research and development or education can be performed by Federal or State government laboratories, universities and other nonprofit organizations, or private industry. Research and development covers a wide range of activities, from the investigation of subatomic particles to the exploration of outer space; it can be ‘‘basic’’ research without particular applications in mind, or it can have a highly specific practical use. Similarly, education includes a wide variety of programs, assisting people of all ages beginning with pre-school education and extending through graduate studies and adult education. Like physical assets, the capital stocks of R&D and education provide services over a number of years and depreciate as they become outdated. For this analysis, physical and R&D capital stocks are estimated using the perpetual inventory method. In this method, the estimates are based on the sum of net investment in prior years. Each year’s Federal outlays are treated as gross investment, adding to the capital stock; depreciation reduces the capital stock. Gross investment less depreciation is net investment. A limitation of the perpetual inventory method is that investment spending may not accurately measure the value of the asset created. However, alternative methods for measuring asset value, such as direct surveys of current market worth or indirect estimation based on an expected rate of return, are especially difficult to apply to assets that do not have a private market, such as highways or weapons systems. In contrast to physical and R&D stocks, the estimate of the education stock is based on the replacement cost method. Data on the total years of education of the U.S. population are combined with data on the cost of education and the Federal share of education spending to yield the cost of replacing the Federal share of the Nation’s stock of education. Additional detail about the methods used to estimate capital stocks appears in a methodological note at the end of this section. It should be stressed that these estimates are rough approximations, and provide a basis only for making broad generalizations. Errors may arise from uncertainty about the useful lives and depreciation rates of different types of assets, incomplete data for historical outlays, and imprecision in the deflators used to express costs in constant dollars. The Stock of Physical Capital This section presents data on stocks of physical capital assets and estimates of the depreciation on these assets. Trends.—Table 6–6 shows the value of the net federally financed physical capital stock since 1960, in constant fiscal year 1992 dollars.3 After rising in the 1960s, the total stock held constant through the 1970s and began rising again in the early 1980s. The stock amounted to $1,838 billion in 1998 and is estimated to increase slightly to $1,872 billion by 2000. In 1998, the national defense capital stock accounted for $642 billion, or 35 percent of the total, and nondefense stocks for $1,196 billion, or 65 percent of the total. Real stocks of defense and nondefense capital show very different trends. Nondefense stocks have grown consistently since 1970, increasing from $476 billion in 1970 to $1,196 billion in 1998. With the investments proposed in the budget, nondefense stocks are estimated to grow to $1,261 billion in 2000. During the 1970s, the nondefense capital stock grew at an average annual rate of 4.5 percent. In the 1980s, however, the growth rate slowed to 2.8 percent annually, with growth continuing at about that rate since then. Real national defense stocks began in 1970 at a relatively high level, and declined steadily throughout the decade, as depreciation from the Vietnam era exceeded new investment in military construction and weapons procurement. Starting in the early 1980s, however, a 3 Constant dollar stock estimates are expressed in chained 1992 dollars, consistent with the January 1996 revisions to the National Income and Product Accounts (NIPAs). 162 ANALYTICAL PERSPECTIVES Table 6–6. NET STOCK OF FEDERALLY FINANCED PHYSICAL CAPITAL (In billions of 1992 dollars) Nondefense Fiscal Year Five year intervals: 1960 .................................................... 1965 .................................................... 1970 .................................................... 1975 .................................................... 1980 .................................................... 1985 .................................................... 1990 .................................................... Annual data: 1995 .................................................... 1996 .................................................... 1997 .................................................... 1998 .................................................... 1999 est. ............................................ 2000 est. ............................................ Total National Defense Direct Federal Capital Total Nondefense Total Water and Power Capital Financed by Federal Grants Other Total Transportation Community and Regional Natural Resources Other 895 964 1,098 1,142 1,237 1,442 1,692 633 599 621 553 498 587 719 262 365 476 589 738 855 973 128 160 182 203 230 256 288 78 96 109 124 145 157 166 50 64 72 79 85 99 121 134 205 295 386 508 599 685 82 145 211 260 313 365 426 24 29 42 67 104 126 136 19 20 24 37 68 86 98 9 11 18 22 23 22 24 1,810 1,820 1,831 1,838 1,855 1,872 700 679 659 642 627 611 1,109 1,141 1,172 1,196 1,228 1,261 325 334 341 343 350 357 174 175 175 174 175 176 151 159 166 169 175 182 784 807 831 853 878 904 493 508 523 537 552 569 145 148 150 152 155 158 106 108 109 110 111 112 39 44 49 54 59 65 large defense buildup began to increase the stock of defense capital. By 1987, the defense stock had exceeded its size at the height of the Vietnam War. In the last few years, depreciation on this increased stock and a slower pace of defense investment have begun to reduce the stock from its recent levels. The stock is estimated to fall from $642 billion in 1998 to $611 billion in 2000. Another trend in the Federal physical capital stocks is the shift from direct Federal assets to grant-financed assets. In 1960, 49 percent of federally financed nondefense capital was owned by the Federal Government, and 51 percent was owned by State and local governments but financed by Federal grants. Expansion in Federal grants for highways and other State and local capital, coupled with relatively slow growth in direct Federal investments by agencies such as the Bureau of Reclamation and Corps of Engineers, shifted the composition of the stock substantially. In 1998, 29 percent of the nondefense stock was owned by the Federal Government and 71 percent by State and local governments. The growth in the stock of physical capital financed by grants has come in several areas. The growth in the stock for transportation is largely grants for highways, including the Interstate Highway System. The growth in community and regional development stocks occurred largely with the enactment of the community development block grant in the early 1970s. The value of this capital stock has grown only slowly in the past few years. The growth in the natural resources area occurred primarily because of construction grants for sewage treatment facilities. The value of this federally financed stock has increased about 30 percent since the mid-1980s. Table 6–7 shows nondefense physical capital outlays both gross and net of depreciation since 1960. Total nondefense net investment has been consistently posi- tive over the period covered by the table, indicating that new investment has exceeded depreciation on the existing stock. The reduced amount of net investment in 1998 reflects the sale of the United States Enrichment Corporation and the privatization of Elk Hills. For some categories in the table, such as water and power programs, net investment has been negative in some years, indicating that new investment has not been sufficient to offset estimated depreciation. The net investment in this table is the change in the net nondefense physical capital stock displayed in Table 6–6. The Stock of Research and Development Capital This section presents data on the stock of research and development, taking into account adjustments for its depreciation. Trends.—As shown in Table 6–8, the R&D capital stock financed by Federal outlays is estimated to be $817 billion in 1998 in constant 1992 dollars. About two-fifths is the stock of basic research knowledge; about three-fifths is the stock of applied research and development. The total federally financed R&D stock in 1998 was about evenly divided between defense and nondefense. Although investment in defense R&D has exceeded that of nondefense R&D in every year since 1979, the nondefense R&D stock is actually the larger of the two, because of the different emphasis on basic research and applied research and development. Defense R&D spending is heavily concentrated in applied research and development, which depreciates much more quickly than basic research. The stock of applied research and development is assumed to depreciate at a ten percent geometric rate, while basic research is assumed not to depreciate at all. 6. 163 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Table 6–7. COMPOSITION OF GROSS AND NET FEDERAL AND FEDERALLY FINANCED NONDEFENSE PUBLIC PHYSICAL INVESTMENT (In billions of 1992 dollars) Total nondefense investment Direct Federal investment Investment financed by Federal grants Composition of net investment Fiscal Year Gross Five year intervals: 1960 ........................ 1965 ........................ 1970 ........................ 1975 ........................ 1980 ........................ 1985 ........................ 1990 ........................ Annual data: 1995 ........................ 1996 ........................ 1997 ........................ 1998 ........................ 1999 est. ................. 2000 est. ................. Depreciation Net Gross Depreciation Net Water and power Composition of net investment Gross Depreciation Net Other Transportation (mainly highways) Community and regional development Natural resources and environment Other 23.7 31.6 30.6 31.9 45.0 43.2 43.5 5.0 7.0 9.1 11.0 13.5 16.4 20.6 18.7 24.6 21.5 20.8 31.5 26.7 22.9 8.7 10.4 6.9 9.6 11.5 13.8 15.7 2.9 3.8 4.4 4.9 5.4 6.9 9.6 5.8 6.6 2.4 4.8 6.0 6.9 6.1 3.0 3.1 2.0 3.7 3.9 2.3 2.0 2.7 3.5 0.5 1.1 2.1 4.6 4.1 15.0 21.2 23.7 22.2 33.5 29.4 27.8 2.1 3.2 4.7 6.2 8.1 9.6 11.0 12.9 18.0 19.1 16.1 25.5 19.8 16.8 12.3 15.2 11.9 7.3 12.3 13.1 12.1 0.1 2.0 4.8 4.0 7.0 3.8 1.5 0.1 0.4 0.9 4.1 6.3 3.0 1.9 0.5 0.4 1.5 0.6 –0.2 –0.1 1.3 55.5 56.8 56.6 50.9 58.9 61.0 24.1 25.0 25.8 26.5 27.1 27.8 31.4 31.8 30.8 24.4 31.8 33.1 18.8 20.3 19.7 14.9 20.2 20.2 11.6 12.0 12.5 12.7 13.0 13.3 7.3 8.3 7.3 2.2 7.2 6.9 1.5 0.6 –0.3 –0.3 0.7 0.5 5.8 7.7 7.6 2.5 6.5 6.4 36.7 36.5 36.9 36.0 38.7 40.8 12.6 13.0 13.3 13.7 14.1 14.5 24.1 23.6 23.6 22.3 24.6 26.2 15.0 14.6 14.9 13.8 15.9 17.1 2.5 2.7 2.6 2.4 2.8 2.5 1.8 1.4 1.3 0.9 1.1 1.3 4.9 4.9 4.8 5.2 4.9 5.3 Table 6–8. NET STOCK OF FEDERALLY FINANCED RESEARCH AND DEVELOPMENT 1 (In billions of 1992 dollars) National Defense Fiscal Year Total Five year intervals: 1970 ................................................................... 1975 ................................................................... 1980 ................................................................... 1985 ................................................................... 1990 ................................................................... Annual data: 1995 ................................................................... 1996 ................................................................... 1997 ................................................................... 1998 ................................................................... 1999 est. ............................................................ 2000 est. ............................................................ 1 Basic Research Nondefense Applied Research and Development Total Basic Research Total Federal Applied Research and Development Total Basic Research Applied Research and Development 235 249 252 288 357 14 19 22 27 32 221 231 229 260 325 194 237 280 304 341 60 88 118 156 205 133 149 162 148 137 429 486 532 592 699 74 106 141 184 237 354 380 391 408 462 371 372 372 372 370 367 38 39 40 41 42 43 333 333 332 331 328 324 407 418 431 445 461 476 261 272 283 295 308 321 146 146 148 150 153 156 778 790 803 817 831 843 298 311 323 336 349 364 479 479 480 481 482 480 Excludes outlays for physical capital for research and development, which are included in Table 6–6. The defense R&D stock rose slowly during the 1970s, as gross outlays for R&D trended down in constant dollars and the stock created in the 1960s depreciated. A renewed emphasis on defense R&D spending from 1980 through 1989 led to a more rapid growth of the R&D stock. Since then, defense R&D outlays have tapered off, depreciation has grown, and, as a result, the net defense R&D stock has stabilized. The growth of the nondefense R&D stock slowed from the 1970s to the late 1980s, from an annual rate of 3.8 percent in the 1970s to a rate of 1.7 percent from 1980 to 1988. Gross investment in real terms fell during much of the 1980s, and about three-fourths of new outlays went to replacing depreciated R&D. Since 1988, however, nondefense R&D outlays have been on an upward trend while depreciation has edged down. As a result, the net nondefense R&D capital stock has grown more rapidly. The Stock of Education Capital This section presents estimates of the stock of education capital financed by the Federal government. As shown in Table 6–9, the federally financed education stock is estimated at $814 billion in 1998 in constant 1992 dollars, rising to $887 billion in 2000. The vast majority of the Nation’s education stock is financed by State and local governments, and by students and their families themselves. This federally financed portion of the stock represents about 3 percent of the Nation’s total education stock.4 Nearly three4 For estimates of the total education stock, see Table 2–4 in Chapter 2, ‘‘Stewardship: Toward a Federal Balance Sheet.’’ 164 ANALYTICAL PERSPECTIVES quarters is for elementary and secondary education, while the remaining one quarter is for higher education. Despite a slowdown in growth during the early 1980s, the stock grew at an average annual rate of 5.1 percent from 1970 to 1998, and the expansion of the education stock is projected to continue under this budget. Note on Estimating Methods This note provides further technical detail about the estimation of the capital stock series presented in Tables 6–6 through 6–9. As stated previously, the capital stock estimates are very rough approximations. Sources of possible error include: Methodological issues.—The stocks of physical capital and research and development are estimated with the perpetual inventory method. A fundamental assumption of this method is that each dollar of investment spending adds a dollar to the value of the capital stock as of the end of the period in which the spending takes place. In reality, the value of the asset created could be more or less than the investment spending. As an extreme example, if a project were canceled before completion, the spending on the project would not result in the creation of any asset. Even where asset value is equal to investment spending, there might be timing differences in spending and the creation of an asset. For example, payments for constructing an aircraft carrier might be made over a period of years, with the asset only created at the end of the period. The historical outlay series.—The historical outlay series for physical capital was based on budget records since 1940 and was extended back to 1915 using data from selected sources. There are no consistent outlay data on physical capital for this earlier period, and the estimates are approximations. In addition, the historical outlay series in the budget for physical capital extending back to 1940 may be incomplete. The historiTable 6–9. cal outlay series for the conduct of research and development began in the early 1950s and required selected sources to be extended back to 1940. In addition, separate outlay data for basic research and applied R&D were not available for any years and had to be estimated from obligations and budget authority. For education, data for Federal outlays from the budget were combined with data for non-Federal spending from the institution or jurisdiction receiving Federal funds, which may introduce error because of differing fiscal years and confusion about whether the Federal Government was the original source of funding. Price adjustments.—The prices for the components of the Federal stock of physical, R&D, and education capital have increased through time, but the rates of increase are not accurately known. Estimates of costs in fiscal year 1992 prices were made through the application of price deflators from the National Income and Product Accounts (NIPAs), but these should be considered only approximations of the costs of these assets in 1992 prices. Depreciation.—The useful lives of physical, R&D, and education capital, as well as the pattern by which they depreciate, are very uncertain. This is compounded by using depreciation rates for broad classes of assets, which do not apply uniformly to all the components of each group. As a result, the depreciation estimates should also be considered approximations. This limitation is especially important in capital financed by grants, where the specific asset financed with the grant is often subject to the discretion of the recipient jurisdiction. Research continues on the best methods to estimate these capital stocks. The estimates presented in the text could change as better information becomes available on the underlying investment data and as improved methods are developed for estimating the stocks based on those data. NET STOCK OF FEDERALLY FINANCED EDUCATION CAPITAL (In billions of 1992 dollars) Fiscal Year Five year intervals: 1960 ............................................................................... 1965 ............................................................................... 1970 ............................................................................... 1975 ............................................................................... 1980 ............................................................................... 1985 ............................................................................... 1990 ............................................................................... Annual data: 1995 ............................................................................... 1996 ............................................................................... 1997 ............................................................................... 1998 ............................................................................... 1999 est. ........................................................................ 2000 est. ........................................................................ Total Education Stock Elementary and Secondary Education Higher Education 64 88 203 292 410 502 650 46 64 159 235 319 374 479 18 25 44 57 91 128 170 721 747 776 814 850 887 523 542 562 590 616 647 198 206 214 224 235 241 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Physical Capital Stocks For many years, current and constant-cost data on the stock of most forms of public and private physical capital—e.g., roads, factories, and housing—have been estimated annually by the Bureau of Economic Analysis (BEA) in the Department of Commerce. With the January 1996 comprehensive revision of the NIPAs, government investment has taken increased prominence. Government investment in physical capital is now reported separately from government consumption expenditures, and government consumption expenditures include depreciation as a measure of the services provided by the existing capital stock. In addition, estimates of depreciation were improved based on recent empirical research.5 The BEA data are not directly linked to the Federal budget, do not extend to the years covered by the budget, and do not separately identify the capital financed but not owned by the Federal Government. For these reasons, OMB prepares separate estimates for budgetary purposes, using techniques that roughly follow the BEA methods. Method of estimation.—The estimates were developed from the OMB historical data base for physical capital outlays and grants to State and local governments for physical capital. These are the same major public physical capital outlays presented in Part I. This data base extends back to 1940 and was supplemented by rough estimates for 1915–1939. The deflators used to convert historical outlays to constant 1992 dollars were based on composite NIPA deflators for Federal, State, and local consumption of durables and gross investment. For 1915 through 1929, deflators were estimated from Census Bureau historical statistics on constant price public capital formation. The resulting capital stocks were aggregated into nine categories and depreciated using geometric rates roughly following those of BEA, which estimates depreciation using much more detailed categories. The geometric rates were 1.9 percent for water and power projects; 2.4 percent for other direct non-defense construction and rehabilitation; 20.3 percent for non-defense equipment; 14.0 percent for defense equipment; 2.1 percent for defense structures; 1.6 percent for transportation grants; 1.7 percent for community and regional development grants; 1.5 percent for natural resources and environment grants; and 1.8 percent for other nondefense grants. Research and Development Capital Stocks Method of estimation.—The estimates were developed from a data base for the conduct of research and 5 BEA explained its new methods in ‘‘Improved Estimates of Fixed Reproducible Tangible Wealth, 1929–95,’’ Survey of Current Business, May 1997, pp. 69–76. BEA’s most recent estimates of capital stocks appear in ‘‘Fixed Reproducible Tangible Wealth in the United States: Revised Estimates for 1995–97 and Summary Estimates for 1925–97,’’ Survey of Current Business, September 1998, pp. 36–46. 165 development largely consistent with the data in the Historical Tables. Although there is no consistent time series on basic and applied R&D for defense and nondefense outlays back to 1940, it was possible to estimate the data using obligations and budget authority. The data are for the conduct of R&D only and exclude outlays for physical capital for research and development, because those are included in the estimates of physical capital. Nominal outlays were deflated by the chained price index for gross domestic product (GDP) in fiscal year 1992 dollars to obtain estimates of constant dollar R&D spending. The appropriate depreciation rate of intangible R&D capital is even more uncertain than that of physical capital. Empirical evidence is inconclusive. It was assumed that basic research capital does not depreciate and that applied research and development capital has a ten percent geometric depreciation rate. These are the same assumptions used in a study published by the Bureau of Labor Statistics estimating the R&D stock financed by private industry.6 More recent experimental work at BEA, extending estimates of tangible capital stocks to R&D, used slightly different assumptions. This work assumed straight-line depreciation for all R&D over a useful life of 18 years, which is roughly equivalent to a geometric depreciation rate of 11 percent. The slightly higher depreciation rate and its extension to basic research would result in smaller stocks than the method used here.7 Education Capital Stocks Method of estimation.—The estimates of the federally financed education capital stock in Table 6–9 were calculated by first estimating the Nation’s total stock of education capital, based on the current replacement cost of the total years of education of the population, including opportunity costs. To derive the Federal share of this total stock, the Federal share of total educational expenditures was applied to the total amount. The percent in any year was estimated by averaging the prior years’ share of Federal education outlays in total education costs. The stock estimates are reduced from those reported last year, due to revisions in the estimated opportunity cost of education. For more information, refer to the technical note in Chapter 2, ‘‘Stewardship: Toward a Federal Balance Sheet.’’ The stock of capital estimated in Table 6–9 is based only on spending for education. Stocks created by other human capital investment outlays included in Table 6–1, such as job training and vocational rehabilitation, were not calculated because of the lack of historical data prior to 1962 and the absence of estimates of depreciation rates. 6 See U.S. Department of Labor, Bureau of Labor Statistics, The Impact of Research and Development on Productivity Growth, Bulletin 2331, September 1989. 7 See ‘‘A Satellite Account for Research and Development,’’ Survey of Current Business, November 1994, pp. 37–71. 166 ANALYTICAL PERSPECTIVES Part IV: ALTERNATIVE CAPITAL BUDGET AND CAPITAL EXPENDITURE PRESENTATIONS A capital budget would separate Federal expenditures into two categories: spending for investment and all other spending. In this sense, Part I of the present chapter provides a capital budget for the Federal Government, distinguishing outlays that yield long-term benefits from all others. But alternative capital budget presentations have also been suggested, and a capital budget process may take many different forms. The Federal budget mainly finances investment for two quite different types of reasons. It invests in capital—such as office buildings, computers, and weapons systems—that primarily contributes to its ability to provide governmental services to the public; some of these services, in turn, are designed to increase economic growth. And it invests in capital—such as highways, education, and research—that contributes more directly to the economic growth of the Nation. Most of the capital in the second category, unlike the first, is not owned or controlled by the Federal Government. In the Table 6–10. discussion that follows, the first is called ‘‘Federal capital’’ and the second is called ‘‘national capital.’’ Table 6–10 compares total Federal investment as defined in Part I of this chapter with investment in Federal capital, which was defined as ‘‘capital assets’’ in Part II of this chapter, and with investment in national capital. Some Federal investment is not classified as either Federal or national capital, and a relatively small part is included in both categories. Capital budgets and other changes in Federal budgeting have been suggested from time to time for the Government’s investment in both Federal and national capital. These proposals differ widely in coverage, depending on the rationale for the suggestion. Some would include all the investment shown in Table 6–1, or more, whereas others would be narrower in various ways. These proposals also differ in other respects, such as whether investment would be financed by borrowing ALTERNATIVE DEFINITIONS OF INVESTMENT OUTLAYS, 2000 (In millions of dollars) Investment Outlays All types of capital 1 Federal capital National capital 31,032 2,625 6,130 7,237 206 ................ ................ ................ ................ ................ 31,032 2,621 1,168 ................ 64 4,461 551 5,128 843 361 1,588 1,225 1,016 2,316 4,461 510 3,754 843 347 1,588 1,225 1,016 1,844 ................ 551 4,829 843 361 1,588 1,225 ................ 1,036 Total construction and rehabilitation ..................................................... Acquisition of major equipment (direct): National defense ............................................................................................ Postal Service ................................................................................................ Air transportation ............................................................................................ Other ............................................................................................................... 64,719 15,588 45,318 47,207 736 2,019 4,849 47,207 736 2,019 4,251 ................ 736 2,019 2,998 Total major equipment ............................................................................... Purchase or sale of land and structures ........................................................... Other physical assets (grants) ........................................................................... 54,811 489 1,178 54,213 489 ................ 5,753 ................ 92 Total physical investment .............................................................................. Research and development: Defense .......................................................................................................... Nondefense .................................................................................................... 121,197 70,290 51,163 37,662 35,942 ................ ................ 1,150 35,460 Total research and development .............................................................. Education and training ....................................................................................... 73,604 52,456 ................ ................ 36,610 52,132 Total investment outlays .................................................................................... 247,257 70,290 139,905 Construction and rehabilitation: Grants: Transportation ............................................................................................ Natural resources and environment .......................................................... Community and regional development ..................................................... Housing assistance .................................................................................... Other grants ............................................................................................... Direct Federal: National defense ........................................................................................ General science, space, and technology .................................................. Natural resources and environment .......................................................... Energy ........................................................................................................ Transportation ............................................................................................ Veterans and other health facilities .......................................................... Postal Service ............................................................................................ GSA real property activities ...................................................................... Other construction ...................................................................................... 1 Total outlays for ‘‘all types of capital‘‘ are equal to the total for ‘‘major Federal investment outlays’’ in Table 6-1. Some capital is not classified as either Federal or national capital, and a relatively small part is included in both categories. 6. 167 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING and whether the non-investment budget would necessarily be balanced. Some of these proposals are discussed below and illustrated by alternative capital budget and other capital expenditure presentations, although the discussion does not address matters of implementation such as the effect on the Budget Enforcement Act. The planning and budgeting process for capital assets, which is a different subject, is discussed in Part II of this chapter together with the steps this Administration is taking to improve it. Investment in Federal Capital The goal of investment in Federal capital is to deliver the right amount of Government services as efficiently and effectively as possible. The Congress allocates resources to Federal agencies to accomplish a wide variety of programmatic goals. Because these goals are diverse and most are not measured in dollars, they are difficult to compare with each other. Policy judgments must be made as to their relative importance. Once amounts have been allocated for one of these goals, however, analysis may be able to assist in choosing the most efficient and effective means of delivering service. This is the context in which decisions are made on the amount of investment in Federal capital. For example, budget proposals for the Department of Justice must consider whether to increase the number of FBI agents, the amount of justice assistance grants to State and local governments, or the number of Federal prisons in order to accomplish the department’s objectives. The optimal amount of investment in Federal capital derives from these decisions. There is no efficient target for total investment in Federal capital as such either for a single agency or for the Government as a whole. The universe of Federal capital encompasses all federally owned capital assets. It excludes Federal grants to States for infrastructure, such as highways, and it excludes intangible investment, such as education and research. Investment in Federal capital in 2000 is estimated to be $70.3 billion, or 28 percent of the total Federal investment outlays shown in Table 6–1. Of the investment in Federal capital, 74 percent is for defense and 26 percent for nondefense purposes. A Capital Budget for Capital Assets Discussion of a capital budget has often centered on Federal capital, called ‘‘capital assets’’ in Part II of this chapter—buildings, other construction, and equipment that support the delivery of Federal services. This includes capital commonly available from the commercial sector, such as office buildings, computers, military family housing, veterans hospitals, research and development facilities, and associated equipment; it also includes special purpose capital such as weapons systems, military bases, the space station, and dams. This definition excludes capital that the Federal Government has financed but does not own.8 8 This definition of ‘‘capital assets’’ is the same as used in the budget for the last two years. Narrower definitions of ‘‘fixed assets’’ were used in earlier budgets. Some capital budget proposals would partition the unified budget into a capital budget, an operating budget, and a total budget. Table 6–11 illustrates such a capital budget for capital assets as defined above. It is accompanied by an operating budget and a total budget. The operating budget consists of all expenditures except those included in the capital budget, plus depreciation on the stock of assets of the type purchased through the capital budget. The capital budget consists of expenditures for capital assets and, on the income side of the account, depreciation. The total budget is the present unified budget, largely based on cash for its measure of transactions, which records all outlays and receipts of the Federal Government. It consolidates the operating and capital budgets by adding them together and netting out depreciation as an intragovernmental transaction. The operating budget has a smaller surplus than the unified budget. This reflects both the relatively small Federal investment in new capital assets and the offsetting effect of depreciation on the existing stock. Depreciation is larger than capital expenditures by $12 billion. The figures in Table 6–11 and the subsequent tables of this section are rough estimates, intended only to be illustrative and to provide a basis for broad generalizations. Table 6–11. CAPITAL, OPERATING, AND UNIFIED BUDGETS: FEDERAL CAPITAL, 2000 1 (In billions of dollars) Operating Budget Receipts .................................................................................................. Expenses: Depreciation ....................................................................................... Other .................................................................................................. 82 1,695 Subtotal, expenses ........................................................................ 1,777 Surplus or deficit (–) .......................................................................... Capital Budget Income: depreciation .............................................................................. Capital expenditures ............................................................................... 105 Surplus or deficit (–) .......................................................................... Unified Budget Receipts .................................................................................................. Outlays .................................................................................................... 12 1,883 1,766 Surplus or deficit (–) .......................................................................... 117 1,883 82 70 1 Historical data to estimate the capital stocks and calculate depreciation are not readily available for Federal capital. Depreciation estimates were based on the assumption that outlays for Federal capital were a constant percentage of the larger categories in which such outlays were classified. They are also subject to the limitations explained in Part III of this chapter. Depreciation is measured in terms of current cost, not historical cost. Some proposals for a capital budget would exclude defense capital (other than military family housing). These exclusions—weapons systems, military bases, and so forth—would comprise three-fourths of the expenditures shown in the capital budget of Table 6–11. If they were excluded, the operating budget would have a surplus that was a little more than the unified budget surplus: a surplus $6 billion higher than the unified budget surplus instead of $12 billion lower as shown above for the complete coverage of Federal capital. Ex- 168 cluding defense makes such a large difference because of its large relative size and the recent pattern of capital asset purchases. The large defense buildup that began in the early 1980s raised the capital stock and depreciation; the buildup was followed by a sharp decline in purchases, while the capital stock and depreciation have declined more slowly. (See the previous section of this chapter.) As a result, capital expenditures for defense in 2000 are estimated to be $18 billion less than depreciation, whereas capital expenditures for nondefense purposes (plus military family housing) are estimated to be $6 billion more. Budget Discipline and a Capital Budget Many proposals for a capital budget, though not all, would effectively dispense with the unified budget and make expenditure decisions on capital asset acquisitions in terms of the operating budget instead. When the Government proposed to purchase a capital asset, the operating budget would include only the estimated depreciation. For example, suppose that an agency proposed to buy a $50 million building at the beginning of the year with an estimated life of 25 years and with depreciation calculated by the straightline method. Operating expense in the budget year would increase by $2 million, or only 4 percent of the asset cost. The same amount of depreciation would be recorded as an increase in operating expense for each year of the asset’s life.9 Recording the annual depreciation in the operating budget each year would provide little control over the decision about whether to invest in the first place. Most Federal investments are sunk costs and as a practical matter cannot be recovered by selling or renting the asset. At the same time, there is a significant risk that the need for a capital asset may change over a period of years, because either the need was not permanent, it was initially misjudged, or other needs become more important. Since the cost is sunk, however, control cannot be exercised later on by comparing the annual benefit of the asset services with depreciation and interest and then selling the asset if its annual services are not worth this expense. Control can only be exercised up front when the Government commits itself to the full sunk cost. By spreading the real cost of the project over time, however, use of the operating budget for expenditure decisions would make the budgetary cost of the capital asset appear very cheap when decisions were being made that compared it to alternative expenditures. As a result, there would be an incentive to purchase capital assets with little regard for need, and also with little regard for the least-cost method of acquisition. A budget is a financial plan for allocating resources— deciding how much the Federal Government should spend in total, program by program, and for the parts 9 The amount of depreciation that typically would be recorded as an expense in the budget year is overstated by this illustration. First, most assets are purchased after the beginning of the year, in which case less than a full year’s depreciation would be recorded. Second, assets may be constructed or built to order, in which case no depreciation would be recorded until the work was completed and the asset put into service. This could be several years after the initial expenditure. ANALYTICAL PERSPECTIVES of each program. The budgetary system provides a process for proposing policies, making decisions, implementing them, and reporting the results. The budget needs to measure costs accurately so that decision makers can compare the cost of a program with its benefit, the cost of one program with another, and the cost of alternative methods of reaching a specified goal. These costs need to be fully included in the budget up front, when the spending decision is made, so that executive and congressional decision makers have the information and the incentive to take the total costs into account in setting priorities. The unified budget does this for investment. By recording investment on a cash basis, it causes the total cost to be compared up front in a rough and ready way with the total expected future net benefits. Since the budget measures only cost, the benefits with which these costs are compared, based on policy makers’ judgment, must be presented in supplementary materials. Such a comparison of total cost with benefits is consistent with the formal method of cost-benefit analysis of capital projects in government, in which the full cost of a capital asset as the cash is paid out is compared with the full stream of future benefits (all in terms of present values).10 This comparison is also consistent with common business practice, in which capital budgeting decisions for the most part are made by comparing cash flows. The cash outflow for the full purchase price is compared with expected future cash inflows, either through a relatively sophisticated technique of discounted cash flows—such as net present value or internal rate of return—or through cruder methods such as payback periods.11 Regardless of the specific technique adopted, it usually requires comparing future returns with the entire cost of the asset up front— not spread over time through annual depreciation.12 Practice Outside the Federal Government The proponents of making investment decisions on the basis of an operating budget with depreciation have sometimes claimed that this is the common practice outside the Federal Government. However, while the practice of others may differ from the Federal budget and the terms ‘‘capital budget’’ and ‘‘capital budgeting’’ 10 For example, see Edward M. Gramlich, A Guide to Benefit-Cost Analysis (2nd ed.; Englewood Cliffs: Prentice Hall, 1990), chap. 6; or Joseph E. Stiglitz, Economics of the Public Sector (2nd ed.; New York: Norton, 1988), chap. 10. This theory is applied in formal OMB instructions to Federal agencies in OMB Circular No. A–94, Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs (October 29, 1992). General Accounting Office, Discount Rate Policy, GAO/OCE–17.1.1 (May 1991), discusses the appropriate discount rate for such analysis but not the foundation of the analysis itself, which is implicitly assumed. 11 For a full textbook analysis of capital budgeting techniques in business, see Harold Bierman, Jr., and Seymour Smidt, The Capital Budgeting Decision (8th ed.; Saddle River, N.J.: Prentice-Hall, 1993). Shorter analyses from the standpoints of corporate finance and cost accounting may be found, for example, in Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance (5th ed.; New York: McGraw-Hill, 1996), chap. 2, 5, and 6; Charles T. Horngren et al., Cost Accounting (9th ed.; Upper Saddle River, N.J.: PrenticeHall, 1997), chap. 22 and 23; Jerold L. Zimmerman, Accounting for Decision Making and Control (Chicago: Irwin, 1995), chap. 3; and Surendra S. Singhvi, ‘‘Capital-Investment Budgeting Process’’ and ‘‘Capital-Expenditure Evaluation Methods,’’ chap. 19 and 20 in Robert Rachlin, ed., Handbook of Budgeting (4th ed.; New York: Wiley, 1999). 12 Two surveys of business practice conducted a few years ago found that such techniques are predominant. See Thomas Klammer et al., ‘‘Capital Budgeting Practices—A Survey of Corporate Use,’’ Journal of Management and Accounting Research, vol. 3 (Fall 1991), pp. 113–30; and Glenn H. Petry and James Sprow, ‘‘The Theory and Practice of Finance in the 1990s,’’ The Quarterly Review of Economics and Finance, vol. 33 (Winter 1993), pp. 359–82. Petry and Sprow also found that discounted cash flow techniques are recommended by the most widely used textbooks in managerial finance. 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING are often used, these terms do not normally mean that capital asset acquisitions are decided on the basis of annual depreciation cost. The use of these terms in business and State government also does not mean that businesses and States finance all their investment by borrowing. Nor does it mean that under a capital budget the extent of borrowing by the Federal Government to finance investment would be limited by the same forces that constrain business and State borrowing for investment. Private business firms call their investment decision making process ‘‘capital budgeting,’’ and they record the resulting planned expenditures in a ‘‘capital budget.’’ However, decisions are normally based on upfront comparisons of the cash outflows needed to make the investment with the resulting cash inflows expected in the future, as explained above, and the capital budget records the period-by-period cash outflows proposed for capital projects.13 This supports the business’s goal of deciding upon and controlling the use of its resources. The cash-based focus of business budgeting for capital is in contrast to business financial statements—the income statement and balance sheet—which use accrual accounting for a different purpose, namely, to record how well the business is meeting its objective of earning profit and accumulating wealth for its owners. For this purpose, the income statement shows the profit in a year from earning revenue net of the expenses incurred. These expenses include depreciation, which is an allocation of the cost of capital assets over their estimated useful life. With similar objectives in mind, the Office of Management and Budget, the Treasury Department, and the General Accounting Office have adopted the use of depreciation on general property, plant, and equipment owned by the Federal Government as a measure of expense in financial statements and cost accounting for Federal agencies.14 Businesses finance investment from net income and other sources as well as borrowing. When they borrow to finance investment, they are constrained in ways that Federal borrowing is not. The amount that a business borrows is limited by its own profit motive and the market’s assessment of its capacity to repay. The greater a business’s indebtedness, other things equal, the more risky is any additional borrowing and the higher is the cost of funds it must pay. Since the profit motive ensures that a business will not want to borrow unless the expected return is at least as high as the cost of funds, the amount of investment that a business will want to finance is limited; it has an incentive to borrow only for projects where the expected return is as high or higher than the cost of funds. Furthermore, 13 A business capital budget is depicted in Glenn A. Welsch et al., Budgeting: Profit Planning and Control (5th ed.; Englewood Cliffs: Prentice Hall, 1988), pp. 396–99. 14 Office of Management and Budget, Statement of Federal Financial Accounting Standards No. 6, Accounting for Property, Plant, and Equipment (November 30, 1995), pp. 5–14 and 34–35. Depreciation is not used as a measure of expense for heritage assets, or for weapons systems and other national defense property, plant, and equipment. Depreciation also is not used as a measure of expense for physical property financed by the Federal Government but owned by State and local governments, or for investment that the Federal Government finances in human capital and research and development. 169 if the risk is great enough, a business may not be able to find a lender. No such constraint limits the Federal Government— either in the total amount of its borrowing for investment, or in its choice of which assets to buy—because of its sovereign power to tax and the wide economic base that it taxes. It can tax to pay for investment; and, if it borrows, its power to tax ensures that the credit market will judge U.S. Treasury securities free from any risk of default even if it borrows ‘‘excessively’’ or for projects that do not seem worthwhile. Most States also have a ‘‘capital budget,’’ but the operating budget is not like the operating budget envisaged by proponents of making Federal investment decisions on the basis of depreciation. State capital budgets differ widely in many respects but generally relate some of the State’s purchases of capital assets to borrowing and other earmarked means of financing. For the debtfinanced portion of investment, the interest and repayment of principal are usually recorded as expenditures in the operating budget. For the portion of investment purchased in the capital budget but financed by Federal grants or by taxes, which may be substantial, State operating budgets do not record any amount. No State operating budget is charged for depreciation.15 States also do not record depreciation expense in the financial accounting statements for governmental funds. They record depreciation expense only in their proprietary (commercial-type) funds and in those trust funds where net income, expense, or capital maintenance is measured.16 Under a proposed change in financial reporting standards, however, depreciation on general capital assets would be recognized as an expense in entity-wide financial statements.17 State borrowing to finance investment, like business borrowing, is subject to limitations that do not apply to Federal borrowing. Like business borrowing, it is constrained by the credit market’s assessment of the State’s capacity to repay, which is reflected in the credit ratings of its bonds. Furthermore, borrowing is usually designated for specified investments, and it is almost always subject to constitutional limits or referendum requirements. Other developed nations tend to show a more systematic breakdown between investment and operating expenditures within their budgets than does the United States, even while they record capital expenditures on a cash basis within the same budget totals. The French budget, for example, is divided into separate titles of 15 The characteristics of State capital budgets were examined in a survey of State budget officers for all 50 States in 1986. See Lawrence W. Hush and Kathleen Peroff, ‘‘The Variety of State Capital Budgets: A Survey,’’ Public Budgeting and Finance (Summer 1988), pp. 67–79. More detailed results are available in an unpublished OMB document, ‘‘State Capital Budgets’’ (July 7, 1987). Two GAO reports examined State capital budgets and reached similar conclusions on the issues in question. See Budget Issues: Capital Budgeting Practices in the States, GAO/AFMD–86–63FS (July 1986), and Budget Issues: State Practices for Financing Capital Projects, GAO/AFMD–89–64 (July 1989). For further information about state capital budgeting, see National Association of State Budget Officers, Capital Budgeting in the States (September 1997). 16 Governmental Accounting Standards Board (GASB), Codification of Governmental Accounting and Financial Reporting Standards as of June 30, 1998, sections 1100.107 and 1400.114–1400.118. 17 Governmental Accounting Standard Board, Exposure Draft, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments (January 31, 1997), paragraphs 33–37 and 273–81. 170 which some are for current expenditures and others for capital expenditures. However, a recent study of European countries found only four that had a real difference between a current budget and a capital budget (Greece, Ireland, Luxembourg, and Portugal); 18 and a survey by the Congressional Budget Office in 1993 found only two developed nations, Chile and New Zealand, that recognize depreciation in their budgets.19 New Zealand, moreover, while budgeting on an accrual basis that generally includes depreciation, requires the equivalent of appropriations for the full cost up front before a department can make net additions to its capital assets.20 Some countries—including Sweden, Denmark, Finland, and the Netherlands—formerly had separate capital budgets but abandoned them a number of years ago.21 The United Kingdom has adopted a rule that it will borrow only for net investment (after depreciation), averaged over the economic cycle; and it has announced plans to budget on an accrual basis, including the depreciation for capital assets, beginning with its budget for 2001–02. Conclusions It is for reasons such as these that the General Accounting Office issued a report in 1993 that criticized budgeting for capital in terms of depreciation. Although the criticisms were in the context of what is termed ‘‘national capital’’ in this chapter, they apply equally to ‘‘Federal capital.’’ ‘‘Depreciation is not a practical alternative for the Congress and the administration to use in making decisions on the appropriate level of spending intended to enhance the nation’s long-term economic growth for several reasons. Currently, the law requires agencies to have budget authority before they can obligate or spend funds. Unless the full amount of budget authority is appropriated up front, the ability to control decisions when total resources are committed to a particular use is reduced. Appropriating only annual depreciation, which is only a fraction of the total cost of an investment, raises this control issue.’’ 22 After further study of the role of depreciation in budgeting for national capital, GAO reiterated that con18 M. Peter van der Hoek, ‘‘Fund Accounting and Capital Budgeting: European Experience,’’ Public Budgeting and Financial Management, vol. 8 (Spring 1996), pp. 39–40. 19 Robert W. Hartman, Statement before the Subcommittee on Economic Development, Committee on Public Works and Transportation, U.S. House of Representatives (May 26, 1993). Hartman stated: ‘‘to our knowledge, only two developed countries, Chile and New Zealand, recognize depreciation in their budgets.’’ 20 New Zealand’s use of depreciation in its budget is discussed in GAO, Budget Issues: The Role of Depreciation in Budgeting for Certain Federal Investments, GAO/AIMD–95–34 (February 1995), pp. 13 and 16–17. 21 The budgets in Sweden, Great Britain, Germany, and France are described in GAO, Budget Issues: Budgeting Practices in West Germany, France, Sweden, and Great Britain, GAO/AFMD–87–8FS (November 1986). Sweden had separate capital and operating budgets from 1937 to 1981, together with a total consolidated budget from 1956 onwards. The reasons for abandoning the capital budget are discussed briefly in the GAO report and more extensively by a government commission established to recommend changes in the Swedish budget system. One reason was that borrowing was no longer based on the distinction between current and capital budgets. See Sweden, Ministry of Finance, Proposal for a Reform of the Swed ish Budget System: A Summary of the Report of the Budget Commission Published by the Ministry of Finance (Stockholm, 1974), chapter 10. 22 GAO, Budget Issues: Incorporating an Investment Component in the Federal Budget, GAO/AIMD–94–40 (November 1993), p. 11. GAO had made the same recommendation in earlier reports but with less extensive analysis. ANALYTICAL PERSPECTIVES clusion in another study in 1995.23 ‘‘The greatest disadvantage . . . was that depreciation would result in a loss of budgetary control under an obligation-based budgeting system.’’ 24 Although that study also focused primarily on what is termed ‘‘national capital’’ in this chapter, its analysis applies equally to ‘‘Federal capital.’’ In 1996 GAO extended its conclusions to Federal capital as well. ‘‘If depreciation were recorded in the federal budget in place of cash requirements for capital spending, this would undermine Congress’ ability to control expenditures because only a small fraction of an asset’s cost would be included in the year when a decision was made to acquire it.’’ 25 Investment in National Capital A Target for National Investment The Federal Government’s investment in national capital has a much broader and more varied form than its investment in Federal capital. The Government’s goal is to support and accelerate sustainable economic growth for the Nation as a whole and in some instances for specific regions or groups of people. The Government’s investment concerns for the Nation are two-fold: • The effect of its own investment in national capital on the output and income that the economy can produce. Reducing expenditure on consumption and increasing expenditure on investment that supports economic growth is a major priority for the Administration. It has reordered priorities in its budgets by proposing increases in selected investments. • The effect of Federal taxation, borrowing, and other policies on private investment. The Administration’s deficit reduction policy has brought about an expansion of private investment, most notably in producers’ durable equipment. In its 1993 report, Incorporating an Investment Component in the Federal Budget, the General Accounting Office (GAO) recommended establishing an investment component within the unified budget—but not a separate capital budget or the use of depreciation—for this type of investment.26 GAO defined this investment as ‘‘federal spending, either direct or through grants, that is directly intended to enhance the private sector’s longterm productivity.’’ 27 To increase investment—both public and private—GAO recommended establishing targets for the level of Federal investment and for a declining path of unified budget deficits over time.28 Such a target for investment in national capital would focus attention on policies for growth, encourage a conscious decision about the overall level of growth-enhancing investment, and make it easier to set spending priorities in terms of policy goals for aggregate forma23 GAO, Budget Issues: The Role of Depreciation in Budgeting for Certain Federal Investments, GAO/AIMD–95–34 (February 1995), pp. 1 and 19–20. 24 Ibid., p. 17. Also see pp. 1–2 and 16–19. 25 GAO, Budget Issues: Budgeting for Federal Capital, GAO/AIMD–97–5 (November 1996), p. 28. Also see p. 4. 26 Incorporating an Investment Component in the Federal Budget, pp. 1–2, 9–10, and 15. 27 Ibid., pp. 1 and 5. 28 Ibid., pp. 2 and 13–16. 6. 171 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING tion of national capital. GAO reiterated its recommendation in another report in 1995.29 Table 6–12. UNIFIED BUDGET WITH NATIONAL INVESTMENT COMPONENT, 2000 (In billions of dollars) Receipts .................................................................................................... Outlays: National investment ............................................................................. Other .................................................................................................... 1,883 140 1,626 Subtotal, outlays .............................................................................. 1,766 Surplus or deficit (–) ............................................................................ 117 Table 6–12 illustrates the unified budget reorganized as GAO recommends to have a separate component for investment in national capital. This component is roughly estimated to be $140 billion in 2000. It includes infrastructure outlays financed by Federal grants to State and local governments, such as highways and sewer projects, as well as direct Federal purchases of infrastructure, such as electric power generation equipment. It also includes intangible investment for nondefense research and development, for basic research financed through defense, and for education and training. Much of this expenditure consists of grants and credit assistance to State and local governments, nonprofit organizations, or individuals. Only 12 percent of national investment consists of assets to be owned by the Federal Government. Military investment and some other ‘‘capital assets’’ as defined previously are excluded, because that investment does not primarily enhance economic growth. A Capital Budget for National Investment Table 6–13 roughly illustrates what a capital budget and operating budget would look like under this definition of investment—although it must be emphasized that this is not GAO’s recommendation. Some proponents of a capital budget would make spending decisions within the framework of such a capital budget and operating budget. But the limitations that apply to the use of depreciation in deciding on investment decisions for Federal capital apply even more strongly in deciding on investment decisions for national capital. Most national capital is neither owned nor controlled by the Federal Government. Such investments are sunk costs completely and can be controlled only by decisions made up front when the Government commits itself to the expenditure.30 In addition to these basic limitations, the definition of investment is more malleable for national capital than Federal capital. Many programs promise long-term intangible benefits to the Nation, and depreciation rates are much more difficult to determine for intangible investment such as research and education than they 29 The Role of Depreciation in Budgeting for Certain Investments, pp. 2 and 19–20. 30 GAO’s conclusions about the loss of budgetary control that were quoted at the end of the section on Federal capital came from studies that predominantly considered ‘‘national capital.’’ Table 6–13. CAPITAL, OPERATING, AND UNIFIED BUDGETS: NATIONAL CAPITAL, 2000 1 (In billions of dollars) Operating Budget Receipts .................................................................................................. Expenses: Depreciation 2 ..................................................................................... Other .................................................................................................. 73 1,626 Subtotal, expenses ........................................................................ 1,699 Surplus or deficit (–) .......................................................................... Capital Budget Income: Depreciation 2 ..................................................................................... Earmarked tax receipts 3 ................................................................... 147 Subtotal, income ............................................................................ Capital expenditures ............................................................................... 110 140 Surplus or deficit (–) .......................................................................... Unified Budget Receipts .................................................................................................. Outlays .................................................................................................... –30 1,883 1,766 Surplus or deficit (–) ..................................................................... 117 1,846 73 37 1 For the purpose of this illustrative table only, education and training outlays are arbitrarily depreciated over 30 years by the straight-line method. This differs from the treatment of education and training elsewhere in this chapter and in Chapter 2. All depreciation estimates are subject to the limitations explained in Part III of this chapter. Depreciation is measured in terms of current cost, not historical cost. 2 Excludes depreciation on capital financed by earmarked tax receipts allocated to the capital budget. 3 Consists of tax receipts of the highway and airport and airways trust funds, less trust fund outlays for operating expenditures. These are user charges earmarked for financing capital expenditures. are for physical investment such as highways and office buildings. These and other definitional questions are hard to resolve. The answers could significantly affect budget decisions, because they would determine whether the budget would record all or only a small part of the cost of a decision when policy makers were comparing the budgetary cost of a project with their judgment of its benefits. The process of reaching an answer with a capital budget would open the door to manipulation, because there would be an incentive to make the operating expenses and deficit look smaller by classifying outlays as investment and using low depreciation rates. This would ‘‘justify’’ more spending by the program or the Government overall.31 A Capital Budget and the Analysis of Saving and Investment Data from the Federal budget may be classified in many different ways, including analyses of the Government’s direct effects on saving and investment. As Parts I and III of this chapter have shown, the unified budget provides data that can be used to calculate Federal investment outlays and federally financed capital stocks. However, the budget totals themselves do not make this distinction. In particular, the budget surplus 31 These problems are also pointed out in GAO, Incorporating an Investment Component in the Federal Budget, pp. 11–12. They are discussed more extensively with respect to highway grants, research and development, and human capital in GAO, The Role of Depreciation in Budgeting for Certain Federal Investments, pp. 11–14. GAO found no government that budgets for the depreciation of infrastructure (whether or not owned by that government), human capital, or research and development (except that New Zealand budgets for the depreciation of research and development if it results in a product that is intended to be used or marketed). 172 or deficit does not measure the Government’s contribution to the nation’s net saving (i.e., saving net of depreciation). A capital budget, it is sometimes contended, is needed for this purpose. This purpose, however, is now fulfilled by the Federal sector of the national income and product accounts (NIPAs) according to one definition of investment. The NIPA Federal sector measures the impact of Federal receipts, expenditures, and deficit on the national economy. It is part of an integrated set of measures of aggregate U.S. economic activity that is prepared by the Bureau of Economic Analysis in the Department of Commerce in order to measure gross domestic product (GDP), the income generated in its production, and many other variables used in macroeconomic analysis. The NIPA Federal sector for recent periods is published monthly in the Survey of Current Business with separate releases for historical data. Estimates for the President’s proposed budget through the budget year are normally published in the budget documents. The NIPA translation of the budget, rather than the budget itself, is ordinarily used by economists to analyze the effect of Government fiscal policy on the aggregate economy.32 Until three years ago the NIPA Federal sector did not divide government purchases of goods and services between consumption and investment. With the comprehensive revision of the national income and product accounts in early 1996, it now makes that distinction.33 The revised NIPA Federal Government account for receipts and expenditures is a current account or an operating account for the Federal Government. The current account excludes expenditures for structures and equipment owned by the Federal Government; it includes depreciation on the federally owned stock of structures and equipment as a measure of the cost of using capital assets and thus as part of the Federal Government’s current expenditures. It applies this treatment to a comprehensive definition of federally owned structures and equipment, both defense and nondefense, similar to the definition of ‘‘capital assets’’ in this chapter.34 The NIPA ‘‘current surplus or deficit’’ of the Federal Government thus measures the Government’s direct contribution to the Nation’s net saving (given the definition of investment that is employed). The 1998 Federal Government current account surplus was reduced $9.4 billion by including depreciation rather than gross in32 See chapter 16 of this volume, ‘‘National Income and Product Accounts,’’ for the NIPA current account of the Federal Government based on the budget estimates for 1999 and 2000, and for a discussion of the NIPA Federal sector and its relationship to the budget. 33 This distinction is also made in the national accounts of most other countries and in the System of National Accounts (SNA), which is guidance prepared by the United Nations and other international organizations. Definitions of investment may vary. Other countries and the SNA do not include the purchase of military equipment as investment. 34 The revised NIPA Federal sector is explained in Survey of Current Business, ‘‘Preview of the Comprehensive Revision of the National Income and Product Accounts: Recognition of Government Investment and Incorporation of a New Methodology for Calculating Depreciation’’ (September 1995), pp. 33–39. As is the case of private sector investment, government investment does not include expenditures on research and development or on education and training. Government purchases of structures and equipment remain a part of gross domestic product (GDP) as a separate component. The NIPA State and local government account has been revised in the same way and includes depreciation on structures and equipment owned by State and local governments that were financed by Federal grants as well as by their own resources. Depreciation is not displayed as a separate line item in the government account: depreciation on general government capital assets is included in government ‘‘consumption expenditures’’; and depreciation on the capital assets of government enterprises is subtracted in calculating the ‘‘current surplus of government enterprises.’’ ANALYTICAL PERSPECTIVES vestment, because depreciation of federally owned structures and equipment was more than gross investment. The 2000 Federal current account surplus is estimated to be reduced $6.5 billion. This is unlike a few years earlier, when the Federal current account deficit was reduced, in some years substantially.35 A capital budget is not needed to capture this effect. Borrowing to Finance a Capital Budget A further issue raised by a capital budget is the financing of capital expenditures. Some have argued that the Government ought to balance the operating budget and borrow to finance the capital budget—capital expenditures less depreciation. The rationale is that if the Government borrows for net investment and the rate of return exceeds the interest rate, the additional debt does not add a burden onto future generations. Instead, the burden of paying interest on the debt and repaying its principal is spread over the generations that will benefit from the investment. The additional debt is ‘‘justified’’ by the additional assets. This argument is at best a justification to borrow to finance net investment, after depreciation is subtracted from gross outlays, not to borrow to finance gross investment. To the extent that capital is used up during the year, there are no additional assets to justify additional debt. If the Government borrows to finance gross investment, the additional debt exceeds the additional capital assets. The Government is thus adding onto the amount of future debt service without providing the additional capital that would produce the additional income needed to service that debt. This justification, furthermore, requires that depreciation be measured in terms of the current replacement cost, not the historical cost. Current cost depreciation is needed in order to measure all activities in the budget on a consistent basis, since other outlays and receipts are automatically measured in the prices of the current year. Current cost depreciation is also needed to obtain a valid measure of net investment. This requires that the addition to the capital stock from new purchases and the subtraction from depreciation on existing assets both be measured in the prices of the same year. When prices change, historical cost depreciation does not measure the extent to which the capital stock is used up each year. As a broad generalization, Tables 6–11 and 6–13 suggest that this rationale would not currently justify much Federal borrowing, if any at all, under the two capital budgets roughly illustrated in this chapter. For Federal capital, Table 6–11 indicates that current cost depreciation is more than gross investment for Federal capital—the capital budget surplus is $12 billion. The rationale of borrowing to finance net investment would not justify the Federal Government borrowing at all to finance its investment in Federal capital; instead, it would have to repay this amount of debt ($12 billion). For national capital, Table 6–13 indicates that current 35 See actuals and estimates for 1989–2000 in table 16–2 of chapter 16 of this volume, ‘‘National Income and Product Accounts.’’ 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING cost depreciation (plus the excise taxes earmarked to finance capital expenditures for highways and airports and airways 36) is less than gross investment but not by a great deal—the capital budget deficit is $30 billion. The rationale of borrowing to finance net investment would justify the Federal Government borrowing this amount ($30 billion) and no more to finance its investment in national capital.37 Even with depreciation calculated in current cost, the rationale for borrowing to finance net investment is not persuasive. The Federal Government, unlike a business or household, is responsible not only for its own affairs but also for the general welfare of the Nation. To maintain and accelerate national economic growth and development, the Government needs to sustain private investment as well as its own national investment. For more than a decade, however, net national saving has been low, both by historical standards and in comparison to the amounts needed to meet the challenges expected in the decades ahead. To the extent that the Government finances its own investment in a way that results in lower private investment, the net increase of total investment in the economy is less than the increase from the additional Federal capital outlays alone. The net increase in total investment is significantly less if the Federal investment is financed by borrowing than if it is financed 36 The capital budget deficit would be about $26 billion larger if current cost depreciation were used instead of earmarked excise taxes for investment in highways and airports and airways. 37 This discussion abstracts from non-budgetary transactions that affect Federal borrowing requirements, such as changes in the Treasury operating cash balance and the net financing disbursements of the direct loan and guaranteed loan financing accounts. See chapter 12 of this volume, ‘‘Federal Borrowing and Debt,’’ and the explanation of Table 12–2. 173 by taxation, because borrowing primarily draws upon the saving available for private (and State and local government) investment whereas much of taxation instead comes out of private consumption. Therefore, the net effect of Federal investment on economic growth would be reduced if it were financed by borrowing. This would be the result even if the rate of return on Federal investment was higher than the rate of return on private investment. For example, if a Federal investment that yielded a 15 percent rate of return crowded out private investment that yielded 10 percent, the net social return would still be positive but it would only be 5 percent.38 From its outset, this Administration has taken major steps to increase the saving available for private investment while also increasing Federal investment for national capital. During the past six years, the large deficit has been replaced by a substantial surplus, and available resources have been shifted to investment in education and training and in science and technology. The present budget proposes to continue to run substantial surpluses, paying down the debt to make room for financing private investment, while protecting high priority Federal investment. A capital budget is not a justification to relax the budget constraints that are contributing to this accomplishment. Any easing would undo the gains from achieving a surplus that have already been achieved and the further gains from the proposals in this budget. 38 GAO considered deficit financing of investment but did not recommend it. See Incorporating an Investment Component in the Federal Budget, pp. 12–13. 174 ANALYTICAL PERSPECTIVES Part V: SUPPLEMENTAL PHYSICAL CAPITAL INFORMATION The Federal Capital Investment Program Information Act of 1984 (Title II of Public Law 98–501; hereafter referred to as the Act) requires that the budget include projections of Federal physical capital spending and information regarding recent assessments of public civilian physical capital needs. This section is submitted to fulfill that requirement. This part is organized in two major sections. The first section projects Federal outlays for public physical capital and the second section presents information regarding public civilian physical capital needs. Projections of Federal Outlays For Public Physical Capital Federal public physical capital spending is defined here to be the same as the ‘‘major public physical capital investment’’ category in Part I of this chapter. It covers spending for construction and rehabilitation, acquisition of major equipment, and other physical assets. This section excludes outlays for human capital, such as the conduct of education and training, and outlays for the conduct of research and development. The projections are done generally on a current services basis, which means they are based on 1999 enacted appropriations and adjusted for inflation in later years. Table 6–14. The current services concept is discussed in Chapter 14, ‘‘Current Services Estimates.’’ Federal public physical capital spending was $109.8 billion in 1998 and is projected to increase to $146.2 billion by 2008 on a current services basis. The largest components are for national defense and for roadways and bridges, which together accounted for almost threefourths of Federal public physical capital spending in 1998. Table 6–14 shows projected current services outlays for Federal physical capital by the major categories specified in the Act. Total Federal outlays for transportation-related physical capital were $28.5 billion in 1998, and current services outlays are estimated to increase to $42.3 billion by 2008. Outlays for nondefense housing and buildings were $12.5 billion in 1998 and are estimated to be $15.5 billion in 2008. Physical capital outlays for other nondefense categories were $15.2 billion in 1998 and are projected to be $26.8 billion by 2008. For national defense, this spending was $53.6 billion in 1998 and is estimated on a current services basis to be $61.6 billion in 2008. Table 6–15 shows current services projections on a constant dollar basis, using fiscal year 1992 as the base year. CURRENT SERVICES OUTLAY PROJECTIONS FOR FEDERAL PHYSICAL CAPITAL SPENDING (In billions of dollars) 1998 Actual Nondefense: Transportation-related categories: Roadways and bridges ...................................................................................... Airports and airway facilities ............................................................................. Mass transportation systems ............................................................................ Railroads ............................................................................................................ Estimate 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 20.2 3.8 3.9 0.6 23.2 3.6 3.8 0.4 25.5 3.9 3.9 0.5 26.7 4.0 4.6 0.7 27.2 4.2 4.9 0.7 27.6 4.3 5.4 0.7 28.1 4.4 5.5 0.7 28.8 4.5 5.6 0.7 29.4 4.6 5.7 0.7 30.1 4.7 5.9 0.8 30.7 4.9 6.0 0.8 Subtotal, transportation ................................................................................. Housing and buildings categories: Federally assisted housing ................................................................................ Hospitals ............................................................................................................ Public buildings 1 ............................................................................................... 28.5 31.0 33.8 35.9 37.0 38.0 38.8 39.7 40.6 41.4 42.3 7.9 1.8 2.8 6.9 1.8 3.3 8.0 1.9 3.4 8.8 1.9 3.7 8.8 1.8 3.9 9.1 1.8 4.0 9.1 1.8 4.0 9.0 1.8 4.1 9.2 1.8 4.2 9.2 1.8 4.2 9.4 1.8 4.3 Subtotal, housing and buildings categories ...................................................... Other nondefense categories: Wastewater treatment and related facilities ..................................................... Water resources projects .................................................................................. Space and communications facilities ................................................................ Energy programs ............................................................................................... Community development programs .................................................................. Other nondefense .............................................................................................. 12.5 12.1 13.3 14.3 14.6 14.9 14.9 14.9 15.2 15.3 15.5 2.5 2.3 3.1 0.9 5.3 1.1 2.8 3.3 2.7 1.1 5.5 7.2 2.9 3.1 3.2 0.8 5.4 6.6 3.1 3.1 3.4 0.9 5.5 7.2 3.1 3.0 3.6 1.2 5.6 6.8 3.2 3.2 3.5 1.3 5.7 7.5 3.3 3.2 3.8 1.5 5.8 7.6 3.3 3.3 3.2 1.5 6.0 7.7 3.4 3.4 3.3 1.5 6.1 7.9 3.5 3.5 3.3 1.6 6.2 8.2 3.5 3.5 3.4 1.6 6.4 8.4 Subtotal, other nondefense. .......................................................................... 15.2 22.6 22.1 23.3 23.2 24.4 25.3 25.0 25.6 26.2 26.8 Subtotal, nondefense ......................................................................................... National defense .................................................................................................... 56.2 53.6 65.7 53.5 69.2 52.0 73.5 54.5 74.8 55.7 77.3 56.9 79.0 58.2 79.5 59.5 81.4 59.1 82.9 60.4 84.6 61.6 Total ............................................................................................................................ 109.8 119.1 121.3 128.0 130.5 134.2 137.2 139.1 140.4 143.3 146.2 1 Excludes outlays for public buildings that are included in other categories in this table. 6. 175 FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING Table 6–15. CURRENT SERVICES OUTLAY PROJECTIONS FOR FEDERAL PHYSICAL CAPITAL SPENDING (In billions of constant 1992 dollars) 1998 Actual Nondefense: Transportation-related categories: Roadways and bridges .................................................................................................... Airports and airway facilities ........................................................................................... Mass transportation systems ........................................................................................... Railroads .......................................................................................................................... Estimate 1999 2000 2001 2002 2003 17.7 3.6 3.4 0.6 20.0 3.4 3.3 0.4 21.5 3.5 3.3 0.5 21.9 3.5 3.8 0.6 21.9 3.6 4.0 0.6 21.7 3.7 4.2 0.6 Subtotal, transportation ............................................................................................... Housing and buildings categories: Federally assisted housing .............................................................................................. Hospitals ........................................................................................................................... Public buildings 1 .............................................................................................................. 25.3 27.0 28.8 29.9 30.0 30.2 7.1 1.8 2.8 6.0 1.8 3.3 6.8 1.8 3.3 7.2 1.7 3.4 7.1 1.7 3.6 7.2 1.6 3.6 Subtotal, housing and buildings categories ................................................................ Other nondefense categories: Wastewater treatment and related facilities .................................................................... Water resources projects ................................................................................................ Space and communications facilities .............................................................................. Energy programs ............................................................................................................. Community development programs ................................................................................ Other nondefense ............................................................................................................ 11.7 11.0 11.9 12.4 12.4 12.4 2.2 2.2 3.0 0.9 4.7 0.9 2.4 3.2 2.6 1.1 4.7 6.9 2.5 2.9 3.1 0.8 4.6 6.2 2.6 2.9 3.2 0.8 4.5 6.5 2.5 2.7 3.3 1.1 4.5 6.0 2.5 2.8 3.1 1.1 4.5 6.6 Subtotal, other nondefense ......................................................................................... 13.9 20.9 20.0 20.6 20.2 20.7 Subtotal, nondefense ....................................................................................................... 50.9 58.9 60.7 62.9 62.6 63.3 National defense .................................................................................................................. 49.5 48.7 46.5 47.7 47.7 47.8 Total .......................................................................................................................................... 100.4 107.7 107.2 110.7 110.3 111.1 1 Excludes outlays for public buildings that are included in other categories in this table. Public Civilian Capital Needs Assessments The Act requires information regarding the state of major Federal infrastructure programs, including highways and bridges, airports and airway facilities, mass transit, railroads, federally assisted housing, hospitals, water resources projects, and space and communications investments. Funding levels, long-term projections, policy issues, needs assessments, and critiques, are required for each category. Capital needs assessments change little from year to year, in part due to the long-term nature of the facilities themselves, and in part due to the consistency of the analytical techniques used to develop the assessments and the comparatively steady but slow changes in underlying demographics. As a result, the practice has arisen in reports in previous years to refer to earlier discussions, where the relevant information had been carefully presented and changes had been minimal. The needs assessment material in reports of earlier years is incorporated this year largely by reference to earlier editions and by reference to other needs assessments. The needs analyses, their major components, and their critical evaluations have been fully covered in past Supplements, such as the 1990 Supplement to Special Analysis D. It should be noted that the needs assessment data referenced here have not been determined on the basis of cost-benefit analysis. Rather, the data reflect the level of investment necessary to meet a predefined standard (such as maintenance of existing highway conditions). The estimates do not address whether the benefits of each investment would actually be greater than its cost or whether there are more cost-effective alternatives to capital investment, such as initiatives to reduce demand or use existing assets more efficiently. Before investing in physical capital, it is necessary to compare the cost of each project with its estimated benefits, within the overall constraints on Federal spending. 176 ANALYTICAL PERSPECTIVES Significant Factors Affecting Infrastructure Needs Assessments Highways 1. Projected annual average growth in travel to the year 2015 .................................................................................... 2. Annual cost to maintain overall 1995 conditions and performance on highways eligible for Federal-aid ............ 3. Annual cost to maintain overall 1995 conditions on bridges .................................................................................... 1.96 percent $33.4 billion (1995 dollars) $5.6 billion (1995 dollars) Airports and Airway Facilities 1. Airports in the National Plan of Integrated Airport Systems with scheduled passenger traffic ........................... 2. Air traffic control towers .............................................................................................................................................. 3. Airport development eligible under airport improvement program for period 1993–1997 ..................................... 528 451 $29.7 billion ($9.4 billion for capacity) (1992 dollars) Mass Transportation Systems 1. Yearly cost to maintain condition and performance of rail facilities over a period of 20 years ............................. 2. Yearly cost to replace and maintain the urban, rural, and special services bus fleet and facilities ..................... $6.1 billion (1995 dollars) $3.6 billion (1995 dollars) Wastewater Treatment 1. Total remaining needs of sewage treatment facilities ............................................................................................... 2. Total Federal expenditures under the Clean Water Act of 1972 through 1999 ...................................................... 3. The population served by centralized treatment facilities: percentage that benefits from at least secondary sewage treatment systems (1996) ................................................................................................................................ 4. States and territories served by State Revolving Funds ........................................................................................... $128 billion (1996 dollars) $72 billion 91 percent 51 Housing 1. Total unsubsidized very low income renter households with worst case needs (5.3 million*) A. In severely substandard units ................................................................................................................................. B. With a rent burden greater than 50 percent .......................................................................................................... * The total is less than the sum because some renter families have both problems. 0.4 million 5.0 million Indian Health (IHS) Care Facilities 1. 2. 3. 4. 5. IHS hospital occupancy rates (1998) ........................................................................................................................... Average length of stay, IHS hospitals (days) (1998) .................................................................................................. Hospital admissions (1998) .......................................................................................................................................... Outpatient visits (1997) ............................................................................................................................................... Eligible population (1999) ............................................................................................................................................ 45.0 percent 4.1 57,114 4,224,095 1,485,508 1. 2. 3. 4. 5. Department of Veterans Affairs (VA) Hospitals (1998) Hospitals ........................................................................................................................................................................ Ambulatory clinics ........................................................................................................................................................ Domiciliaries ................................................................................................................................................................. Vet centers ..................................................................................................................................................................... Nursing homes .............................................................................................................................................................. 166 544 40 206 132 Water Resources Water resources projects include navigation (deepwater ports and inland waterways); flood and storm damage protection; irrigation; hydropower; municipal and industrial water supply; recreation; fish and wildlife mitigation, enhancement, and restoration; and soil conservation. Potential water resources investment needs typically consist of the set of projects that pass both a benefit-cost test for economic feasibility and a test for environmental acceptability. In the case of fish and wildlife mitigation or restoration projects, the set of eligible projects includes those that pass a cost-effectiveness test. Investment Needs Assessment References General U.S. Advisory Commission on Intergovernmental Relations (ACIR). High Performance Public Works: A New Federal Infrastructure Investment Strategy for America, Washington, D.C., 1993. U.S. Advisory Commission on Intergovernmental Relations (ACIR). Toward a Federal Infrastructure Strategy: Issues and Options, A–120, Washington, D.C., 1992. U.S. Army Corps of Engineers, Living Within Constraints: An Emerging Vision for High Performance Public Works. Concluding Report of the Federal Infrastructure Strategy Programs. Institute for Water Resources, Alexandria, VA, 1995 U.S. Army Corps of Engineers, A Consolidated Performance Report on the Nation’s Public Works: An Update. Report of the Federal Infrastructure Strategy Program. Institute for Water Resources, Alexandria, VA, 1995. 6. FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING 177 Surface Transportation Department of Transportation. 1997 Status of the Nation’s Surface Transportation System: Conditions and Performance: Report to Congress. 1997. This report discusses roads, bridges, and mass transit. Health Facilities Construction Program. Indian Health Service Proposed Replacement Hospital at Shiprock, New Mexico (CIN A–09–88–00008). June, 1989. Office of Technology Assessment. Indian Health Care (OTA 09H 09290). April, 1986. Airports and Airways Facilities Federal Aviation Administration. The National Plan of Integrated Airport Systems Report, April 1995. Wastewater Treatment Environmental Protection Agency, Office of Water. 1996 Needs Survey Report to Congress. (EPA 832–R–87–003). Federally Assisted Housing U.S. Department of Housing and Urban Development, Office of Policy Planning and Development, Tabulations of 1993 American Housing Survey. Indian Health Care Facilities Indian Health Service. Priority System for Health Facility Construction (Document Number 0820B or 2046T). September 19, 1981. Indian Health Service. Trends in Indian Health— 1997. 1997. Office of Audit, Office of Inspector General, U.S. Department of Health and Human Services. Review of Water Resources National Council on Public Works Improvement. The Nation’s Public Works, Washington, D.C., May, 1987. See ‘‘Defining the Issues—Needs Studies,’’ Chapter II; Report on Water Resources, Shilling et al., and Report on Water Supply, Miller Associates. Frederick, Kenneth D., Balancing Water Demands with Supplies: The Role of Demand Management in a World of Increasing Scarcity, Report for the International Bank of Reconstruction and Development, Washington, D.C. 1992. 7. RESEARCH AND DEVELOPMENT EXPENDITURES In the last one hundred years, science and technology have fundamentally transformed our lives, from the ways we travel and communicate, to the food we eat; from the manner in which we learn, to the quality of our health care and our ability to create a cleaner environment. The next century offers new fields of research and innovation and potential solutions to some of society’s most pressing challenges. Technological advances continue to strengthen the ties between Americans and the rest of the world, enabling new business endeavors, providing access to news and information from anywhere on the globe, and improving cultural understanding. As the forces of innovation and globalization gain momentum, the 21st Century promises to be an era of great opportunity for the entire world, propelled by new and remarkable developments. In the latter half of this century, the Federal Government has played a critical role in spurring and sustaining scientific and technological advances. Among other feats, Government-sponsored research and development put Americans on the moon, explored the oceans, boosted agricultural productivity, harnessed the atom, devised more effective treatments for cancers, found the remains of lost civilizations, tracked weather patterns and earthquake faults, created the Internet, and deciphered the chemistry of life. Numerous studies show technological innovation and scientific discovery generated at least half of the Nation’s productivity growth over the last 50 years, created millions of high-skill, high-wage jobs, and improved the quality of life in America. Table 7–1. In the last year alone, Federal government funding of research and development produced numerous impressive results, including the first photograph of a planet outside our own solar system, creation of the world’s fastest supercomputer, identification of the gene that causes Parkinson’s Disease, and a host of other notable achievements. The future holds even greater possibilities. Scientists and engineers in many disciplines are within reach of even more exciting advances. Building on decades of experimental and theoretical developments, they will be able to rely on new and sophisticated research tools for future discoveries—supercomputers that can make trillions of calculations in a second, particle accelerators and electron microscopes that can decipher atoms and the nature of matter, and space telescopes that can reach to parts of the universe previously unexplored. In particular, computational science—supercomputer modeling of extremely complex systems such as the global climate, the human body, and galaxies—is emerging as a new and significant branch of research, providing insights not likely to occur through experimentation or theorizing alone. Continued leadership in science and technology is a cornerstone of the President and the Vice President’s vision for America. The Administration is proposing $77.1 billion in outlays for research and development (R&D) activities in 2000, including $38.7 billion for civilian R&D—a six percent increase over 1999. Chapter Seven of the Budget includes a lengthier discussion of R&D activities and shows budget authority data. FEDERAL RESEARCH AND DEVELOPMENT EXPENDITURES (Outlays, dollar amounts in millions) 1998 Actual 1999 Estimate 2000 Proposed Dollar Change: 1999 to 2000 Percent Change: 1999 to 2000 By Agency Defense ..................................................................................................................... Health and Human Services ..................................................................................... National Aeronautics and Space Administration ...................................................... Energy ....................................................................................................................... National Science Foundation .................................................................................... Agriculture .................................................................................................................. Commerce ................................................................................................................. Interior ........................................................................................................................ Transportation ............................................................................................................ Veterans Affairs ......................................................................................................... Environmental Protection Agency ............................................................................. Other .......................................................................................................................... 37,844 12,685 10,251 6,730 2,302 1,546 835 451 661 564 527 958 37,186 14,226 10,032 7,194 2,334 1,671 862 519 573 658 638 966 34,992 15,582 9,620 7,495 2,634 1,707 864 618 1,324 662 652 983 –2,194 1,356 –412 301 300 36 2 99 751 4 14 17 –6% 9% –4% 4% 11% 2% 0% 19% 131% 1% 2% 2% TOTAL .................................................................................................................. 75,354 76,859 77,133 274 0% By R&D Type Basic Research ......................................................................................................... Applied Research ...................................................................................................... Development .............................................................................................................. Equipment .................................................................................................................. 14,892 14,545 43,325 937 16,248 15,447 42,281 937 17,598 15,916 40,560 1,021 1,350 469 –1,721 84 8% 3% –4% 9% 179 180 ANALYTICAL PERSPECTIVES Table 7–1. FEDERAL RESEARCH AND DEVELOPMENT EXPENDITURES—Continued (Outlays, dollar amounts in millions) 1998 Actual 1999 Estimate 2000 Proposed Dollar Change: 1999 to 2000 Percent Change: 1999 to 2000 Facilities ..................................................................................................................... 1,659 1,950 2,038 88 5% TOTAL .................................................................................................................. 75,354 76,859 77,133 274 0% By Civilian Theme Basic Research ......................................................................................................... Applied Research ...................................................................................................... Development .............................................................................................................. Equipment .................................................................................................................. Facilities ..................................................................................................................... 13,839 10,410 8,370 608 1,251 15,096 10,923 8,343 608 1,455 16,448 11,350 8,616 707 1,581 1,352 427 273 99 126 9% 4% 3% 16% 9% SUBTOTAL ........................................................................................................... 34,478 36,425 38,702 2,277 6% By Defense Theme Basic Research ......................................................................................................... Applied Research ...................................................................................................... Development .............................................................................................................. Equipment .................................................................................................................. Facilities ..................................................................................................................... 1,053 4,135 34,951 329 408 1,152 4,524 33,934 329 495 1,150 4,566 31,950 314 457 –2 42 –1,984 –15 –38 0% 1% –6% –5% –8% SUBTOTAL ........................................................................................................... 40,876 40,434 38,431 –2,003 –5% R&D Support to Universities ......................................................................................... 12,528 13,719 14,427 708 5% 8. UNDERWRITING FEDERAL CREDIT AND INSURANCE Federal programs offer direct loans and/or loan guarantees for housing, education, business, and exports. At the end of FY 1998, there were $217 billion in Federal direct loans outstanding and $882 billion in loan guarantees. In addition, net lending by Governmentsponsored enterprises totaled $2.0 trillion. The Federal Government also insures bank, thrift, and credit union deposits up to $100,000, guarantees vested define-benefit pensions, and insures against disasters, specified international investment risks, and various other risks. These diverse programs are operating in the context of rapidly evolving private financial markets that are making some of their functions less necessary while generating both new risks and new opportunities. Thus, program managers are continually reassessing their roles and seeking to improve their effectiveness in dynamic financial markets. The introduction to this chapter summarizes key changes in financial markets and their effects on Federal programs. • Its first section is a crosscutting assessment of the rationale for a continued Federal role in providing credit and insurance, performance measures for credit programs, and criteria for reengineering credit programs so as to enhance their benefits in relation to costs. • The second section reviews Federal credit programs and GSEs in four sectors: housing, education, business and community development, and exports, noting the rationale and goals of these programs. It highlights a housing consortium recently created to help program managers integrate with evolving private sector practices, and efforts to improve the effectiveness of student, business, and international credit programs. • The final section assesses recent developments in Federal deposit insurance, pension guarantees, and disaster insurance. the world. Interstate banking and branching are almost nationwide, and growing numbers of large financial institutions serve global markets. Capital market financing is available to smaller companies and for a broader range of purposes than before. Secondary markets are the main source of financing for mortgages, and a rapidly growing source of financing for household durables, consumer credit, and small business loans. Nonbanks and nonfinancial firms are helping to funnel funds from capital markets to small clients in cities and in rural areas. Faster and cheaper information and communications systems have revolutionized ‘‘back office’’ functions. These can be consolidated to achieve economies of scale and located anywhere in the world where capable help is available and economical. From these locations, communications can bring the ‘‘back office’’ to the front line on a computer terminal in the office of any realtor or supplier or in any storefront or kiosk. From a timely information base, credit servicing and workout have become much more efficient. While the increased globalization of financial institutions and capital markets provides extensive benefits, it also makes domestic market conditions more sensitive to events abroad. In 1998, the continued Asian crisis and further events in Russia and Brazil resulted in a flight to liquidity and safety. This drove down U.S. Treasury bond yields dramatically, and also helped to lower rates in the mortgage market and on highgrade corporate debt. Some markets, however, were temporarily disrupted; related to this was an increase in business borrowing from banks, rather than directly from capital markets. Less creditworthy borrowers faced higher rates or were temporarily unable to find funds. As a result of this episode, awareness of the potential for discontinuities in financial markets has increased. Evolving Financial Markets Financial markets have been evolving rapidly in recent years. Both intermediaries—banks and the many non-bank firms engaged in financial services—and capital markets have been reaching out to new clients that they did not serve a few years ago. Competition for business within and across industry lines has become more intense as legal and regulatory restrictions segmenting financial markets have eased. Massive databanks and increasingly sophisticated analytical methods are being used to find creditworthy borrowers among people and businesses previously thought ineligible for private credit. Moreover, funds are flowing more readily to their most productive uses across the country and around Impact on Federal Programs These changes are affecting the roles, risks, and operations of Federal credit and insurance programs. • In some cases, private credit and insurance markets may evolve sufficiently to take over functions previously left to Federal programs. More likely, they may take away the best risks among those who have been borrowing from the Government or with its guarantee, leaving the Federal program facing a smaller pool of riskier clients. If the Government is aware of this in time, the result may be new benefit/cost calculations that might help to redesign—or to end—the program. If the Government is caught unaware, the result may be greater cost for the taxpayers. 181 182 ANALYTICAL PERSPECTIVES • At the same time, Federal programs can take advantage of the growing private capability. They can leverage it to provide additional assistance to their clients. With careful attention to the incentives faced by the private sector, they can develop a variety of partnerships with private entities. And they can contract with the private sector wherever it can provide specific credit servicing, collection, or asset disposition services more efficiently. Insurance programs, too, are affected by the evolution of the financial marketplace. That is most obvious for deposit insurance, which now backs a recovered, consolidating industry, but one that has assumed the risks inherent in providing a growing array of increasingly sophisticated services, including many off-balance sheet activities, often on a world-wide basis. Depository institutions have become increasingly vulnerable to adverse shocks in foreign financial markets through loans, investments, foreign exchange transactions, and off-balI. ance-sheet activities. In pensions, the Government guarantees defined-benefit plans, but defined-contribution plans play an increasing role—attracting the support of younger workers in an aging workforce. This trend may accelerate as the retirement of the baby boom generation nears. In disaster insurance, private firms are gaining a better understanding of their risks and exploring ways to diversify them in capital markets. In this changing environment for Federal credit and insurance programs, this chapter asks three questions. First, what is our current understanding of the roles of these programs? Second, how well they are achieving their goals? And finally, could they be re-engineered to achieve greater benefits in relation to costs? A consortium of housing program managers, and managers of student, business, and international credit programs will be working intensively on this third question next year. A CROSS-CUTTING ASSESSMENT The Federal Role In most lines of credit and insurance, the private market efficiently allocates resources to meet societal demands, and Federal intervention is unnecessary. However, Federal intervention may improve on the market outcome in some situations. The following are six standard situations where this may be the case, 1 together with some examples of Federal programs that address them. • Information failures occur when there is an asymmetry in the information available to different agents in the marketplace. A common Federal intervention in such cases is to require the more knowledgeable agent, such as a financial institution, to provide certain information to the other party, for example, the borrower or investor. A different sort of information failure occurs when the private market deems it too risky to develop a new financial instrument or market. This is rare nowadays, but it is worth remembering that the Federal Government developed the market for amortized, fixed-rate mortgages and other innovations in housing finance. • Externalities occur when people or entities either do not pay the full cost of their activities (e.g., pollution) or do not receive the full return. Federal credit assistance for students is justified in part because, although people with more education are likely to have higher income and even better health, they do not receive the full benefits of their education. Their colleagues at work, the residents of their community, and the citizens of the 1 Economics textbooks also list pure public goods, like national defense, where it is difficult or impossible to exclude people from sharing the full benefits of the goods or services once they have been produced. It is hard to imagine credit or insurance examples in this category. Nation also benefit from their greater knowledge and productivity. • Economic disequilibrium is a third rationale for Federal intervention. This is one rationale for deposit insurance. If many banks and thrifts are hurt simultaneously by an economic shock, such as accelerating inflation in the 1970s, and depositors have a hard time knowing which ones may become insolvent, deposit insurance prevents a contagious rush to withdraw deposits that could harm the whole economy. • Failure of competition, resulting from barriers to entry, economies of scale, or foreign government intervention, may also argue for Federal intervention—for example, by reducing barriers to entry, as has often been done recently, by negotiating to eliminate or reduce foreign government subsidies, or by providing countervailing Federal credit assistance to American exporters. • Incomplete markets occur if producers do not provide credit or insurance even though customers might be willing to pay for it. One example would be catastrophic insurance, where there is a small risk of a very large loss; a disaster that occurred sooner rather than later could bankrupt the insurer even if premiums were set at an appropriate level to cover long-term cost. Another example is caused by ‘‘moral hazard’’ problems, where the borrower or insured could behave so as to take advantage of the lender or insurer. This is the case for pension guarantees, where sponsors might underfund plans, and for deposit insurance, where banks might take more risk to earn a higher return. In these cases, the Government’s legal and regulatory powers provide an advantage in comparison with a private insurer. 8. UNDERWRITING FEDERAL CREDIT AND INSURANCE • In addition to correcting market failures, Federal credit programs are often used to redistribute resources by providing subsidies from the general taxpayer to disadvantaged regions or segments of the population. In reviewing its credit and insurance programs, the Federal Government must continually reassess whether the direct and indirect benefits to the economy exceed the direct and indirect costs. This assessment should include the costs associated with redirecting scarce resources away from other investments. In some situations, the market may have recently become capable of providing financial services, and older Federal programs may need to be modified or ended to make room for private markets to develop. Private providers in similar circumstances might go bankrupt, merge, or change their line of business; for Federal programs, a policy decision and usually a change in law are needed to eliminate overcapacity. In other instances, Federal programs may be redesigned to encourage the development of private credit market institutions or to target Federal assistance more efficiently to groups still unable to obtain credit and insurance in the private market. What Are We Trying to Achieve? If the main Federal role is to provide credit and insurance that private markets would not provide—to stretch the boundaries in providing credit and insurance—the Federal goal is to achieve a net impact that benefits society. Together, these objectives make the standard for success of a Federal credit or insurance program more daunting than for a private credit or insurance firm. For credit and insurance, as for all other programs, implementation of the Government Performance and Results Act (GPRA) will help to assess whether programs are achieving their intended results in practice— and will improve the odds for success. GPRA requires agencies to develop strategic plans in consultation with the Executive Branch, the Congress, and interested parties; this process should refine and focus agency missions. The strategic plans set long-range goals, annual performance plans set milestones to be reached in the coming year, and annual performance reports will measure agency progress toward achieving their goals. GPRA defines four kinds of measures for assessing programs: inputs (the resources used), outputs (the goods or services produced), outcomes (the gross effects on society achieved by the program), and net impacts (the effects net of those that would have occurred in the absence of the program, e.g., with private financing). For credit and insurance programs, interesting interrelationships among these measures provide the keys to program success. Net impacts assess the net effect of the program on intended outcomes compared with what would have occurred in the absence of the program. They exclude, for example, effects that would have been achieved with private credit in the absence of the program. Among 183 the net impacts toward which Federal credit programs strive are: a net increase in home ownership, a net increase in higher education graduates, a net increase in small businesses, a net increase in exports, and a net increase in jobs. For credit programs, the first key to achieving any of these net impacts is outreach. In the spirit of the Federal role, programs need to identify borrowers who would not get private credit. They need to reach out to underserved populations (e.g., low-income or minority people) and neighborhoods (urban and rural). They need to encourage the start-up of new activities (e.g., beginning farmers, new businesses, new exporters). They need to reach their legislatively targeted populations (e.g., students, veterans). Federal lending is often to higher-risk borrowers, or for higher-risk purposes. In order to assist certain target groups or encourage certain activities, credit may be extended for longer periods or at a lower cost to the borrower. Achieving program objectives, however, also means finding ways to assist those borrowers at the boundary of private credit markets to repay their loans. This is not just a financial goal; it is necessary to achieve the program’s social purpose. Home ownership requires mortgage repayment. Education that enhances income is associated with repayment of student loans. Remaining in business with a good credit rating requires repayment of small business, farm, and export loans. And loan repayment is inherent in program cost-effectiveness. Moreover, when the Federal Government bears risk for less creditworthy borrowers and does so in a way that fails to assist them to repay, they struggle with high debt burdens and are left with poor credit records. With implementation of the Federal Credit Reform Act of 1990, Federal credit programs began to reconcile the tension between helping certain groups or purposes and ‘‘business-like’’ financial management. With the implementation of GPRA, they may begin to see program success and financial success as two facets of the same goal. The challenge is usually to identify ‘‘boundary’’ borrowers and to structure the loan and its servicing (including technical assistance) so as to pull those borrowers toward financial and programmatic success. In some cases, savings from improved credit program management may be reinvested to pull more borrowers across that boundary. Outputs and outcomes, therefore, have an interrelationship which is crucial to the performance of credit programs. The most obvious output of Federal credit programs is the number and value of direct loans originated or loans guaranteed. But volume alone does not achieve the objectives of Federal credit programs; indeed, large volume or market share may mean that private lenders are displaced. Loans must have certain characteristics in order to achieve the desired outcomes and net impacts; these characteristics are therefore part of the desired program output. Because of the Federal role, output measures should include an estimate of the percent of loans or guaran- 184 tees originated going to borrowers who would otherwise not have access to private credit, and the percent of loans or guarantees originated going to specific target groups (e.g., veterans) or for specific purposes. Because of the Federal goal, output measures should include the percent of loans or guarantees that are current. This should be compared with the percent that were expected to be current at this point in the repayment cycle. To assess the latter, program data should be analyzed to determine whether repayment prospects are enhanced by particular characteristics of loan structure (such as higher initial borrower equity), of loan origination (such as verifying borrower financial status), of loan servicing (such as prompt counseling), or of guarantee conditions (such as lender risk-sharing). When such characteristics help to control the cost of credit programs and to achieve desired outcomes, then these characteristics should be measured as part of the program’s output. The linkage between such output characteristics and the outcomes of Federal credit programs is not always fully recognized. For example, one desired outcome is to reach underserved populations or neighborhoods. To achieve this outcome, it would be useful to monitor whether loans are going to borrowers who would not otherwise have access to credit, or to specific target groups. Other desired outcomes include supporting investment important to the economy, encouraging startup of new activities, or contributing to sustained economic development. To achieve these outcomes, it would be useful to monitor whether the program’s loans and operating procedures have characteristics that would enhance borrower repayment. Inputs. Program cost is also a performance measure. For credit and insurance programs, it is a continuing challenge to understand and control the risks that the Government assumes and to measure the inherent cost. This is especially important in view of the rapid changes in financial markets discussed above and the increasingly complex financial instruments. The subsidy cost of Federal credit programs, cumulated over time for each cohort of the program’s loans or loan guarantees, is the main input. Another is the administrative cost of the program, including the cost of credit extension, direct loan servicing and guaranteed loan monitoring, collecting on delinquent loans and collateral, and other administrative costs such as policy making or systems development. The relationship between these inputs is also crucial for credit programs. Careful servicing of loans, for example, can reduce default costs, and perhaps total program costs. So good servicing is good financial management for the taxpayer. But good servicing is also an ANALYTICAL PERSPECTIVES art, which can—by assisting borrowers to repay—help to achieve the program’s performance objectives. Private servicing of loans offers many examples of the gains from matching repayment to the borrower’s flow of income, treating borrowers in different circumstances differently, and in other ways maximizing the borrower’s chances to make good. In sum, there are three relationships that seem to hold the key to excellence in credit program performance: the relationship between repayment and the achievement of program objectives, the relationship between the characteristics of credit program outputs and desired outcomes, and the relationship between subsidy cost and good servicing and program administration. Another important key to success is the speed with which the program adapts to market changes, including its ability to provoke or harness private markets into meeting Federal goals. Principles for Re-engineering In order to improve the effectiveness of Federal credit programs, OMB will be working with agencies to identify ways to re-engineer credit management. This effort will focus on improving servicing, will consider consolidation of functions such as data collection and asset disposition, will rely on the private sector when that would improve efficiency, will devise incentives to improve management and reduce cost, and will ensure the development of data for management and subsidy estimation. The focus will be on managing the servicing, workout, and sale of any collateral efficiently. For example, why does the Federal Government pay claims on guaranteed loans and handle the workout, instead of leaving this to the originating lender? Why does the Government take over collateral? How do the timing and results of our asset disposition compare with private practice? Why do we make loans to finance purchases of collateral? What incentives and penalties would be useful for programs and program staff? For guaranteed loan originators? For contractors who service Federal loans or dispose of collateral? OMB has developed a tentative set of principles for re-engineering credit programs that builds on OMB Circular A–129 and initial research. These will be modified by lessons learned as they are put into practice. The resulting principles are intended to improve the performance of Federal credit programs in the years ahead. Because private markets are extending credit where it was formerly unavailable, and because there is little purpose to re-engineering programs which are not justified, these principles start with basic questions of program justification. But their main focus is on how programs should be carried out. 8. UNDERWRITING FEDERAL CREDIT AND INSURANCE 185 Program Justification 1. Credit assistance should be provided only when it has been demonstrated that private credit markets cannot achieve clearly defined Federal objectives. What is the objective? Is access to private credit available? If not, why not? If so, is there a reason why private terms and conditions should be supplemented or subsidized? To what extent? 2. Credit assistance should be provided only when it is the best means to achieve Federal objectives. Can private credit markets be developed? Can market imperfections be overcome by information, regulatory changes, or other means? Would small grants for downpayments, capitalization for State, local, or nonprofit revolving funds, or other approaches be more efficient? 3. Credit assistance should be provided only when its benefits exceed its cost. Analyze benefits and costs in accordance with OMB Circular A–94. Program Design 4. Credit programs should minimize substitution for private credit. What features of program design minimize displacement? Encourage and supplement private lending? To what extent is credit for this objective expanded by this program compared with what would be available in the absence of the program? What is the economic cost of the lending bumped from the credit queue? 5. Credit programs should stretch their resources and better meet their objectives by controlling the risk of default. What features of program design minimize risk? Are there incentives and penalties for loan originators and servicers to minimize risk? What features of the loan contract, the process of origination, the quality of servicing, and the workout procedures minimize risk? Do borrowers have an equity interest? Is maturity shorter than the economic life of the asset financed? Are the timing and amount of payment matched with availability of resources? Is timely reminder and technical assistance provided? How well is risk understood, measured, and monitored? 6. Credit programs should stretch their resources to better meet their objectives by minimizing cost; where program purposes allow, most should be self-sustaining. Do fees and interest cover the Government’s cost, including administration? Are interest rates specified as a percent of market rates on comparable maturity Treasury securities? Are charges for riskier borrowers proportional to their higher cost? Program Operations 7. Credit programs should take advantage of the capacity, flexibility, and expertise available in competitive private markets unless the benefits of direct Federal operations can be shown to exceed the cost. Private financial institutions may offer convenient access for borrowers, potential for graduation to private credit, economies of scale, ready adjustment to changing volume or location of loans, and knowledge of current credit conditions and techniques. 8. The lender (in the case of a loan guarantee), the servicer, and the providers of workout and asset disposition services should have a stake in the successful and timely repayment of the loan or collections on claims and collateral. Originators of guaranteed loans should bear a share of each dollar of default loss, and— unless other arrangements can be shown to be more cost-effective—should be responsible for handling workout. Each contract should include incentives for good performance, and penalties, including loss of business, for poor performance. The duration and scope of each contract or agreement should be limited so as to maximize specialization and competition, unless those are offset by economies of scale in operations and monitoring. 9. Criteria should be established for participation in Federal loan guarantee programs by lenders, servicers, and providers of workout and asset disposition services. These criteria should include financial and capital requirements for lenders and servicers not regulated by a Federal financial institution regulatory agency, and may include fidelity/surety bonding and/or errors and omissions insurance, qualification requirements for officers and staff, and requirements of good standing and performance in relation to other contracts and debts. Lenders transferring and/or assigning servicing, and lenders or servicers transferring and/or assigning workout or asset disposition, must use only entities which have qualified under the Federal participation criteria. 186 10. ANALYTICAL PERSPECTIVES When there are economies of scope or scale, the data gathering and analysis, servicing, workout, asset disposition, or other functions of specific credit programs should be combined or coordinated. The sequence of operations should be streamlined, and accountability for each step clearly defined. Program Monitoring 11. Each program should maintain or receive monthly loan-by-loan transaction data and a system whereby this information triggers servicing, workout, and follow-up actions. These data shall be linked by loan number to an analytical database showing characteristics of loans, borrowers, projects financed, financial information, credit ratings, and other data in a form suitable for use in subsidy estimation and loan pricing. 12. Each program should design and carry out steps to foresee problems, and to inspect, audit, and assess the program’s operations. Methods should be benchmarked against the best practices used elsewhere. The program and its lenders, servicers, and other contractors should experiment with and assess ways in which the effectiveness or efficiency of the program might be improved or costs reduced. II. CREDIT IN FOUR SECTORS Housing Credit Programs and GSEs The Federal Government provides loans and loan guarantees to expand access to home ownership to people who lack the savings, income, or credit history to qualify for a conventional home mortgage and to finance rental housing for low-income persons. The Departments of Housing and Urban Development (HUD), Veterans Affairs (VA), and Agriculture (USDA) made $150 billion of loan and loan guarantee commitments in 1998, helping nearly 1.5 million households. Roughly 1 out of 7 single-family mortgages originated in the United States receives assistance from one of these programs. • HUD’s Federal Housing Administration (FHA) runs a Mutual Mortgage Insurance Fund that guaranteed $90 billion in mortgages for one million households in 1998. Over three-fourths of these went to first-time homebuyers. • The VA assists veterans, members of the Selected Reserve, and active duty personnel to purchase homes as a recognition of their service to the Nation. The program substitutes the Federal guarantee for the borrower’s down payment. In 1998, VA provided $40 billion in guarantees to 369,000 borrowers. • USDA’s Rural Housing Service (RHS) guarantees up to 90 percent of an unsubsidized home loan. The program’s emphasis is on reducing the number of rural residents living in substandard housing. In 1998, $2.8 billion of guarantees went to 39,400 households. In addition, RHS offers a single-family direct loan program and both direct and guaranteed multi-family mortgages. FHA guarantees mortgages for multi-family housing and other specialized properties. Housing Finance Challenges and Opportunities Private banks, thrifts, and mortgage bankers, which originate the mortgages that FHA, VA, and RHS guarantee, may deal with all three programs, as well as with the Government National Mortgage Association (Ginnie Mae), which guarantees timely payment on se- curities based on pools of these mortgages. In addition, the same private firms originate conventional mortgages, many of which are securitized by Governmentsponsored enterprises—the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Many of these firms already use or are planning to use electronic loan origination and are moving toward electronic underwriting. Behind such underwriting are data warehouses showing default experience by type of loan, borrower characteristics, home location, originator, and servicer, and models relating these factors to default cost. ‘‘Web lending’’ is also on the horizon. These changes offer both challenges and opportunities to the Federal mortgage guarantors and Ginnie Mae. They are challenged to become electronically accessible to their clients and loan originators. They are challenged to assess and monitor their risks more closely, now that private firms are reaching out to the better risks among their potential clients. They also have an opportunity to provide better service, to lower cost and improve efficiency, and to target their efforts to help borrowers to retain their homes. The Housing Consortium In FY 1998, the FHA, VA, and RHS housing guarantee programs and Ginnie Mae formed The Federal Housing Consortium to adapt to the rapid shift to electronic underwriting and other technological developments in the private sector. The Consortium is the focus of agency efforts to keep abreast of changes in the housing credit market, accelerate adoption of best practices, establish common standards where possible, and make government systems compatible with the private sector. Data Systems. The Consortium members are currently pooling resources to create a prototype data warehouse through which all members will have access to integrated data on program and borrower characteristics, lender and loan performance. It will provide timely, easily retrievable information, giving managers 8. UNDERWRITING FEDERAL CREDIT AND INSURANCE the ability to monitor the changing risk and cost of guarantees and the performance of guaranteed loan originators and servicers. Using the data warehouse and learning from each other and from the private sector, the Consortium will seek to improve loan origination, performance measurement, risk sharing and pricing, and asset disposition. The Consortium is also working with Ginnie Mae to integrate and enhance Ginnie’s two databases for use of all Consortium members. Ginnie’s databases, the Issuer Portfolio Analysis Database System (IPADS) and the Correspondence Portfolio Analysis Database System (CPADS), receive monthly data from issuers of mortgage-backed securities, and monitor current performance by loan, originator, servicer, mortgage pool, security, and security issuer. Performance can be tracked and compared, taking account of differences between region, economic conditions, size and type of business, and age of portfolio. Because Ginnie Mae guarantees timely payment of principal and interest on securities based on pools of mortgages guaranteed by FHA and VA, the issuers of these securities are almost always FHA and VA servicers. About 65 percent of RHS’s single-family loans are also placed in Ginnie Mae pools. Thus, although the current analytical system is designed fill Ginnie Mae’s needs, the same data and much the same system could be very useful to the loan guarantee programs. For example, CPADS could enable FHA and VA to monitor and assess how well the firms that originate and service the loans they guarantee are doing their jobs. Ginnie Mae has shared CPADS with FHA and VA for many years. RHS began a partnership with Ginnie Mae in 1998, and this year will have access to loan and lender performance data to analyze RHS loan guarantees. Ginnie Mae has committed to making enhancements to IPADS/CPADS that will provide additional benefits to all three loan guarantee programs. The integration of IPADS and CPADS and an initial round of enhancements will be implemented this year. Further enhancements are planned in the future to enable the agencies to monitor and respond effectively to technological, institutional, and financial developments in the residential mortgage market. Loan Origination. Electronic underwriting provides convenient, faster service at a lower cost to both lenders and borrowers. Freddie Mac and Fannie Mae are among the leaders in developing such systems and encouraging their use. Both FHA and VA now permit mortgage lenders to use approved automated underwriting systems to originate their loans. Both undertook pilot assessment of Freddie Mac’s ‘‘Loan Prospector’’ system; VA approved its use in October 1997 and FHA in February 1998. Both are now working with Fannie Mae to pilot ‘‘Desktop Underwriter,’ and with other large mortgage originators. FHA and VA are also increasing the use of electronic data interchange to obtain information electronically from mortgage originators and servicers and 187 to provide notifications and approvals for faster client services. The RHS plans to develop the capacity to accept electronic loan originations from their participating lenders. Utilizing electronic loan origination technology will add significant benefits to loan processing efficiency and timeliness for both RHS and the lenders. RHS is also exploring using some form of automated underwriting and credit scoring. RHS’s goal is to implement these improvements as soon as possible, but in order to ensure proper planning and maximum efficiency, complete adoption of these procedures is several years away. Performance Measurement. Measuring loan servicing performance establishes a baseline for assessing changes to servicing practice. Monthly data will not only give housing programs a better understanding of how their guarantee portfolio behaves, but also how the federally guaranteed housing market as a whole performs. This information is critical for developing good performance standards. FHA has created a loss mitigation program that scores lender performance on loss mitigation annually and provides incentives to lenders to hold down mortgage defaults and hold down FHA claim and property disposition costs relative to other lenders in each FHA insuring district. RHS reviews at least 10 percent of the loans serviced by a lender every two years. If deficiencies in loan servicing or underwriting are noted, the lender is requested to take corrective action; its eligibility will be terminated if it does not comply. Since 1998, RHS has commissioned external audits of its largest loan servicers. The audits focus on both loan origination and loan servicing requirements. These audits have helped to pinpoint program weaknesses contributing to loan delinquencies. In addition, they serve to alert and train servicers on RHS guidelines and reporting requirements. Risk Sharing and Pricing. Risk-based pricing is emerging in the conventional mortgage market as an important means by which lenders can take on more risk. Technology is giving lenders much more precise ability to assess the initial default risk associated with making a particular loan. This increasingly precise underwriting technology, in turn, allows lenders and insurers to adjust fees or loan rates and/or raise insurance premiums to reflect risk and loan cost accurately. Federal loan guarantee programs will need to assess the impact of private sector customization on their loan portfolios, and may need to adopt a similar pricing structure or face adverse selection and larger losses. Currently, premiums are fixed in statute and vary only slightly with one dimension of risk, the initial loanto-value ratio. Asset Disposition. Common wisdom in the mortgage industry is to avoid foreclosure because that is when significant losses occur, including costs for maintenance and marketing. Managers of Federal guarantee pro- 188 grams have found that the best practice is to avoid taking the property into possession, and having to manage and dispose of foreclosed properties. RHS already operates under the ‘‘best practice’’ for asset disposition. The lender is paid the loss claim, including costs incurred for up to six months after the default. After the loss claim is paid, RHS has no involvement in the loan, and it becomes the sole responsibility of the lender. In FY 2000, RHS will shorten the loss claim period from six months to three months through regulatory changes to encourage lenders to dispose of properties as efficiently as possible. In 1998 the Administration proposed and Congress passed legislation giving new authority to FHA to pay claims prior to foreclosure, thereby allowing FHA to pass along defaulted notes to the private sector for servicing and/or disposition. When fully implemented, this new authority will reduce foreclosures and, for properties that do go into foreclosure, this new authority will greatly reduce the time such properties remain on the market. In 1999, VA will eliminate its role in the disposition of foreclosed properties by outsourcing this function to the private sector. Thus, all three housing guarantee programs will be following ‘‘best practice.’’ RHS Single-family Direct Loans RHS also provides subsidized single-family direct loans to very-low-and low-income borrowers unable to get credit elsewhere to purchase, rehabilitate, or repair homes. The most recent and on-going servicing improvement effort is the implementation of the Dedicated Loan Origination Service System (DLOS), which centralizes the servicing of the 502 Direct Loan program. DLOS has been a recent servicing improvement and, in conjunction with 2 major regulations implemented between 1996 and 1997, reduced RHS’s direct loan subsidy rate by 40 percent. RHS Multi-family Loans RHS also offers direct loans to private developers to construct and rehabilitate multi-family rental housing for very-low-to low-income residents, elderly households, or handicapped individuals. It provided $151 million in direct loans in 1998, that will provide 7,890 units for very-low-income tenants. For the first time under permanent authorization, RHS obligated $39.7 million in loan guarantees for multi-family housing in 1998. The loan level is proposed to increase to $200 million for FY 2000, providing 5,380 new units for low to moderate income tenants. The cost of this program is primarily due to the subsidized interest component because default rates are expected to be low. The budget includes a legislative proposal to remove the requirement to provide subsidized interest on these loans, which would result in a negative subsidy. The budget also provides $40 million, a 33 percent increase over FY 1999, for the farm labor housing program ($25 million in loans; $15 million in grants) as part of USDA’s civil rights initiative, which will provide an estimated 960 units for minority farmworkers and their families. ANALYTICAL PERSPECTIVES Fannie Mae and Freddie Mac Because Fannie Mae and Freddie Mac, the largest Government-sponsored enterprises (GSEs), are the dominant firms in the secondary mortgage market, their business activities have a significant impact on the housing finance sector of the U.S. economy. These GSEs engage in two main lines of business: they issue and guarantee mortgage-backed securities (MBS), and they hold portfolios of mortgages, MBS, and other mortgage-related securities that they finance by borrowing. As of September 1998, Fannie Mae and Freddie Mac had $1.7 trillion outstanding in mortgages purchased or guaranteed. Of this, $0.6 trillion was retained in the GSEs’ portfolios and $1.1 trillion was issued as MBSs (excluding MBSs held in portfolio). The Federal Housing Enterprises Safety and Soundness Act of 1992 reformed Federal regulation of Fannie Mae and Freddie Mac. This Act created the Office of Federal Housing Enterprise Oversight (OFHEO) to manage the Government’s exposure to risk by conducting examinations and enforcing minimum and riskbased capital requirements. Both GSEs have consistently met the minimum capital requirements, which are based on leverage ratios. The risk-based capital requirements will be based on a stress test. OFHEO has solicited public comment on a variety of issues related to a risk-based capital regulation and, in June 1996, published the first of two Notices of Proposed Rulemaking (NPR) on risk-based capital. OFHEO expects to publish its second NPR for public comment in 1999. As required by the 1992 Act, the Secretary of Housing and Urban Development (HUD) issued a final regulation at the end of 1995 that established new goals for Fannie Mae and Freddie Mac to foster housing credit for lower-income families and under-served communities. For 1997 through 1999, the regulation requires each GSE to devote: • 42 percent of its mortgage purchases to finance dwelling units that are affordable by low-and moderate-income families; • 24 percent of its purchases to finance units in central cities, rural areas, and other metropolitan areas with low and moderate median family income and high concentrations of minority residents; and • 14 percent of its purchases to finance units that are special affordable housing for very-low-income families and low-income families living in low-income areas. During 1993–95, the GSEs were subject to transitional goals, and in 1996, they were subject to interim goals that were slightly lower than the goals for 1997–99. Fannie Mae and Freddie Mac each achieved all three goals in 1996 and 1997. HUD expects to publish new affordable housing goals for 2000 and thereafter in 1999. In recent years, the GSEs have sought to maintain rapid growth in their earnings through even more rapid growth of their debt-financed holdings of mortgage as- 8. UNDERWRITING FEDERAL CREDIT AND INSURANCE sets. From September 1997 to September 1998, outstanding retained GSE holdings grew 28 percent in dollar volume, while total outstanding mortgage purchases grew 14 percent. Increased asset volumes imply increased risk exposures, as do some new activities, such as purchases of lower quality mortgages. By contrast, some of the GSEs’ new business activities and innovations may enhance their risk management capabilities. The GSEs’ use of credit scores and automated underwriting may improve risk measurement and therefore mitigate the credit risks inherent in purchasing and securitizing mortgages. Similarly, the gradual development of risk-based pricing may more closely tie revenues to potential losses. For holders of mortgage credit risk, sophisticated risk measurement and pricing tools continue to lead to shifts in the distribution of risk among the GSEs, private mortgage insurers, lenders, and mortgage investors. Federal Home Loan Bank System The Federal Home Loan Bank System (FHLBS) was established in 1932 to provide liquidity to home mortgage lenders. The FHLBS carries out this mission by issuing debt and using the proceeds to make secured loans, called advances, to its members. Member institutions primarily use advances to finance residential mortgages and other housing related assets. Federally chartered thrifts are required to be FHLBS members, but membership is open to state-chartered thrifts, commercial banks, credit unions, and insurance companies on a voluntary basis. As of September 30, 1998, 6,806 financial institutions were FHLBS members, an increase of 388 over September 1997. About 71 percent of members are commercial banks, 25 percent are thrifts, and the remaining 4 percent are credit unions and insurance companies. However, nearly 50 percent of outstanding FHLBS advances were held by Federally-chartered thrifts as of September 30. The FHLBS reported net income of $1.6 billion for the year ending September 30, 1998, up from $1.5 billion in the previous 12 months. System capital rose from $18 billion to $21 billion, while the ratio of capital to assets fell from 5.7 percent to 5.4 percent. Average return on equity was about 6.7 percent, after adjustment for payment of interest to the Resolution Funding Corporation (REFCorp). Outstanding advances to members reached $246 billion at September 30, 1998, a 35 percent increase over the $182 billion outstanding a year earlier. System investments other than advances fell to $136 billion, or about 35 percent of total assets, as of September 30, 1998. A year earlier, investments stood at $138 billion, or 42 percent of total assets. The Federal Home Loan Banks are required by law to pay $300 million annually toward the cost of interest on bonds issued by the Resolution Funding Corporation and the greater of 10 percent of net income or $100 million to the Affordable Housing Program (AHP). In addition, the FHLBanks are required to provide discounted advances for targeted housing and community investment lending through a Community Investment 189 Program. The need to generate income to meet the REFCorp and AHP obligations and still provide a competitive return on members’ investment was a driving force behind the substantial increase in the System’s investment activity in recent years. The System also needs to service a capital requirement which is based on members’ asset size, mortgage holdings, and advances, rather than the amount of System risk. In the past, the FHLBS’ exposure to credit risk was virtually nonexistent. All advances to member institutions are collateralized, and the FHLBanks can call for additional or substitute collateral during the life of an advance. No FHLBank has ever experienced a loss on an advance. While the FHLBanks face minimal credit risk on advances, the System’s investment activities, including certain ‘‘pilots,’’ do create certain risks. To control the System’s risk exposure, the Federal Housing Finance Board (FHFB), the System’s regulator, has established regulations and policies that the FHLBanks must follow to evaluate and manage their credit and interest rate risk. FHLBanks must file periodic compliance reports, and the FHFB conducts an annual on-site examination of each FHLBank. Each FHLBank’s board of directors must establish risk management policies that comport with FHFB guidelines. As a pilot activity, the FHFB has allowed some of the FHLBanks to underwrite mortgages jointly with their members. Under one such pilot, the FHLBanks finance the loans and assume the interest rate and prepayment risks, while the members originate and service the loans and assume the credit risk. All assets held by a FHLBank under this pilot are required, pursuant to the terms of the program, to be credit enhanced to at least the level of an AA security. Through these pilot programs, the FHLBS is expanding its traditional role as a wholesale lender as a means of promoting housing finance and community investment. The FHLBS’ investment activities also pose important public policy issues about the degree to which the composition of assets on the FHLBS’ balance sheet adequately reflects the mission of the System. Over the last year, outstanding advances as a percentage of the System’s outstanding debt increased by nearly ten percent. In addition, as of September 30, 1998, about 60 percent of advances outstanding had a remaining maturity of greater than one year—up from about 40 percent a year earlier. Despite this progress, investments (other than advances) currently represent over one-third of the System’s assets and are used to conduct extensive arbitrage—the System issues debt securities at close to U.S. Treasury rates and invests the proceeds in other, higher-yielding securities. In fact, in 1998 the FHLBS issued $2.4 trillion in debt securities and became the world’s largest issuer of debt. However, the majority of debt issued by the System is short-term, and total debt outstanding was only about $336 billion at the end of 1998. An enormous, liquid, and efficient capital market exists for conventional home mortgages today. And, over 190 ANALYTICAL PERSPECTIVES the years, the FHLBS has played an important role in developing and expanding this market. The FHLBanks continue to provide valuable services to their members. They assist members in remaining competitive in housing finance and managing interest-rate risk, and offer their members a reliable source of funds, as evidenced by the recent increase in advances. However, as a result of GSE and Federal agency sponsor- ship of secondary markets and the increasing presence of private securitizers, lenders have access to substantial liquidity sources other than FHLBS advances. As with other GSEs, the role and risks of the FHLBS will be tested in the face of rapidly changing financial markets and potential changes in the structure and activities of the industry served by the FHLBS. Education Credit Programs and GSEs Student Loans The Department of Education helps to finance student loans through two major programs: the Federal Family Education Loan (FFEL) program and the William D. Ford Federal Direct Student Loan (FDSL) program. Eligible institutions of higher education may choose to participate in either program. Loans are available to students and their parents regardless of income. Borrowers with low family incomes are eligible for higher interest subsidies. In 2000, more than 6 million borrowers will receive 9.4 million loans totaling over $41 billion. Of this amount, $34 billion is for new loans and the remainder is to consolidate existing loans. Loan levels have risen dramatically over the past 10 years as a result of rising educational costs, higher loan limits, and more eligible borrowers. The upward trend is expected to continue for the next five years. The Federal Family Education Loan program provides loans through a complex administrative structure involving over 4,100 lenders, 36 State and private guaranty agencies, 50 participants in the secondary markets, and nearly 4,000 participating schools. Under FFEL, banks and other eligible lenders loan private capital to students and parents, guaranty agencies insure the loans, and the Federal Government reinsures the loans against borrower default. In FY 2000, FFEL lenders will disburse more than 6 million loans exceeding $25 billion in principal. Lenders bear two percent of the default risk, and the government and guaranty agencies are responsible for the remainder. The Department also makes administrative payments to guaranty agencies and pays interest subsidies to lenders. The Federal Direct Student Loan program was authorized by the Student Loan Reform Act of 1993 to enable students and parents to obtain and repay loans more easily than under the FFEL program. Under FDSL, the Federal Government provides loan capital directly to 1,300 schools, which then disburse loan funds to students—greatly streamlining loan delivery for students, parents, and schools. In FY 2000, the FDSL program will generate more than 3.4 million loans with a total of over $16 billion. The program offers a variety of flexible repayment plans including income-contingent repayment, under which annual repayment amounts vary based on the income of the borrower and payments can be made over 25 years. Reform proposals. The Administration is proposing legislation to restructure and improve the efficiency of the guaranteed loan system and to provide additional benefits to students. Proposed changes will save $4.6 billion over five years. The Administration is proposing to extend the temporary Consolidation Loan policies included in the recent Higher Education Amendments of 1998 (HEA) through the end of fiscal year 2000. This proposal would maintain the interest rate on Direct Consolidation Loans—scheduled to increase on February 1, 1999—at the 91-day Treasury bill rate plus 2.3 percent, producing significant savings for students while encouraging competition between the Direct Loan and Federal Family Education Loan programs. The proposal would also maintain the reduced FFEL Consolidated Loan holder fee at 0.62 percent of outstanding volume, rather than increase the fee to 1.05 percent on February 1, 1999, as required under the HEA. The Administration is also proposing to improve the management and collection of defaulted loans through four new initiatives, three of which build on provisions enacted in the HEA. First, the amount guaranty agencies may retain on default collections will be reduced from 24 percent to 18.5 percent—approximately the rate paid on loans collected by the Department of Education through competitively awarded contracts. This will provide the guaranty agencies greater incentive to increase collections on defaulted loans in order to bolster revenues. Second, the Administration proposes increasing true risk-sharing between the Federal government and guaranty agencies. Complementing the reduction of re-insurance to guaranty agencies from 98 to 95 percent specified in HEA, the Administration proposes eliminating provisions that allow agencies to recoup this 5 percent cost from subsequent default collections. As such, the Administration expects greater emphasis on default avoidance activities. Third, the HEA extended the time before lenders may submit a default claim on a delinquent loan from 180 days to 270 days. In order to promote risk-sharing and increase lenders’ incentive to bring these loans back into repayment, the Administration is proposing that interest not continue to accrue during this additional 90-day period. Again, this proposal provides default avoidance incentives. Lastly, data from the Department of Health and Human Services’ National Directory of New Hires (NDNH) will be made available to assist in the Department of Education’s default collection efforts. Defaulted 191 8. UNDERWRITING FEDERAL CREDIT AND INSURANCE debtor data matching will provide the Department of Education with current borrower address information for collection activities. The Administration is also proposing to expand the use of voluntary agreeme
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