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FISCAL YEAR 2003

ANALYTICAL
PERSPECTIVES

BUDGET OF

THE

UNITED STATES GOVERNMENT

THE BUDGET DOCUMENTS
Budget of the United States Government, Fiscal Year 2003
contains the Budget Message of the President and information on
the President’s budget and management priorities, including assessments of agencies’ performance.
Analytical Perspectives, Budget of the United States Government, Fiscal Year 2003 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 list of Federal programs by agency and account, as well as by budget function.
Historical Tables, Budget of the United States Government,
Fiscal Year 2003 provides data on budget receipts, outlays, surpluses or deficits, Federal debt, and Federal employment over an
extended time period, generally from 1940 or earlier to 2007. To
the extent feasible, the data have been adjusted to provide consistency with the 2003 Budget and to provide comparability over time.
Budget of the United States Government, Fiscal Year 2003—
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.
Budget System and Concepts, Fiscal Year 2003 contains an
explanation of the system and concepts used to formulate the President’s budget proposals.
Budget Information for States, Fiscal Year 2003 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.
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.whitehouse.gov/omb/budget
For more information on access to electronic versions of the budget
documents (except CD–ROMs), call (202) 512–1530 in the D.C. area
or toll-free (888) 293–6498. To purchase a CD–ROM or printed documents call (202) 512-1800.

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 2002

For sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: (202) 512–1800 Fax: (202) 512–2250
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ISBN 0–16–051029–5

TABLE OF CONTENTS
Page

Budget and Performance Integration
1.

Budget and Performance Integration .....................................................................

3

Economic and Accounting Analyses
2.

Economic Assumptions .............................................................................................

19

3.

Stewardship: Toward a Federal Balance Sheet .....................................................

31

Federal Receipts and Collections
4.

Federal Receipts .......................................................................................................

55

5.

User Fees and Other Collections .............................................................................

83

6.

Tax Expenditures .....................................................................................................

95

Special Analyses and Presentations
7.

Federal Investment Spending and Capital Budgeting ..........................................

131

8.

Research and Development ......................................................................................

159

9.

Credit and Insurance ...............................................................................................

177

10.

Aid to State and Local Governments ......................................................................

237

11.

Federal Employment and Compensation ................................................................

255

12.

Strengthening Federal Statistics .............................................................................

261

Federal Borrowing and Debt
13.

Federal Borrowing and Debt ...................................................................................

267

Budget Enforcement Act Preview Report
14.

Preview Report .........................................................................................................

283

Current Services Estimates
15.

Current Services Estimates .....................................................................................

295

Other Technical Presentations
16.

Trust Funds and Federal Funds .............................................................................

351

17.

National Income and Product Accounts ..................................................................

367

18.

Comparison of Actual to Estimated Totals .............................................................

373

19.

Relationship of Budget Authority to Outlays .........................................................

381
i

ii

TABLE OF CONTENTS—Continued
Page

20.

Off-Budget Federal Entities and Non-Budgetary Activities .................................

383

21.

Outlays to the Public, Net and Gross .....................................................................

387

Information Technology Investments
22.

Program

Performance

Benefits

from

Major

Information

Technology

Investments ...............................................................................................................

391

Scorecard Standards for Success
23.

Scorecard Standards for Success .............................................................................

411

Ranking Regulatory Investments in Public Health
24.

Ranking Regulatory Investments in Public Health ...............................................

419

Budget System and Concepts and Glossary
25.

Budget System and Concepts and Glossary ...........................................................

425

Detailed Functional Tables
26.

Detailed Functional Tables ......................................................................................

447

Federal Programs by Agency and Account
27.

Federal Programs by Agency and Account .............................................................

495

List of Charts and Tables ......................................................................................................

699

BUDGET AND PERFORMANCE INTEGRATION

1

1. BUDGET AND PERFORMANCE INTEGRATION
This Budget marks a significant step on the long
road to a results-oriented government. It starts using
performance measures to develop policies, to make
budget decisions, and to improve everyday program
management. The Administration is creating a government that promotes the outcomes that Americans
want—such as better education for our children, the
freedom to travel safely, and protection of our health—
and does this in a cost-effective and efficient way.
Achieving better program performance—particularly
better performance for each dollar spent—is a high priority of this Administration. Congressional interest, reflected in the Government Performance and Results Act
of 1993, set agencies to identifying performance goals,
planning to achieve them, and reporting on results.
What has been missing is systematic use of these
measures to make decisions. In particular, performance
measures are not directly linked to the budget—and
yet it is the budget that drives policy development,
allocates resources, and has undeveloped potential to
support better management.
• Past and planned results are not shown with
budget requests, let alone linked in a cost-andresults relationship.
• Program managers responsible for achieving results often do not control the resources they use
or have flexibility to use them efficiently.
• Performance and cost data are recorded in separate systems and not integrated to provide timely,
analytical, feedback to decision-makers and managers.
• Americans cannot readily assess program results,
and cannot compare performance and cost across
programs.
Budgeting for Results. Eager to make government
work better, the Administration used all of the performance information it could gather in making decisions
for this Budget. It also began the transition to change
the burden of proof, asking agencies and advocates to
supply evidence of program effectiveness instead of assuming effectiveness in the absence of evidence to the
contrary. In addition to funding high priority programs,
the Budget devotes dollars to programs that are rated
effective. The Budget proposes reforms for ineffective

programs, reduces their funding or terminates them.
Policy changes are proposed to increase program effectiveness and to improve the efficiency of programs and
support services. The first section of this chapter, Budgeting for Results, analyzes shifts in resources and
changes in policies made on the basis of this intense
focus on performance.
Foundation for Results. To create a foundation for
continual improvement in the effectiveness of government, the President has begun to make results the
focus of the budget process. Planning and evaluation
will be integral to budgeting. The budget takes the
first steps toward showing expected results and the
resources requested to achieve each result. To give
managers full information about programs and to encourage efficient use of resources, the budget needs a
uniform measure of the full annual cost of the resources
used that will be charged to each program and activity.
In October, the President transmitted to Congress
the Managerial Flexibility Act of 2001. Title II of that
Act will charge employing agencies for the full annual
accruing cost of Federal pensions and retiree health
benefits, as reflected in this Budget. The Administration is developing proposals to charge for support services, capital assets, and hazardous substances cleanup
where these resources are used. As explained in the
second section of this chapter, Foundation for Results,
these proposals do not change total budget outlays,
budget concepts, or public-private cost comparisons.
However, they would provide a better assessment of
program costs.
Managing for Results. Budget and Performance Integration is one of five interrelated initiatives in The
President’s Management Agenda, rolled out in August.
The others are Strategic Management of Human Capital, Competitive Sourcing, Expanded Electronic Government, and Improved Financial Performance. The
third section of this chapter, Managing for Results,
shows that the objective of these five initiatives together is to create a transformation to year-round performance orientation through all levels of the Federal
government.

3

4

ANALYTICAL PERSPECTIVES

‘‘We are not alone...’’
Governments here and around the world are devising strategies to assess and manage for results—both outputs (i.e., products and services delivered) and outcomes (i.e., the end result that is being sought, such as clean streets or reduced crime).
Here in the United States, a growing number of States, counties and municipalities use ‘‘performance budgeting’’ as a tool for
making policy and management decisions. Charlotte, North Carolina, and Dayton, Ohio undertake regular performance measurement. Sunnyvale, California has become internationally recognized for performance budgeting—allocating funding for tasks
rather than for personnel, equipment, and supplies, with quantified objectives that are expected to be achieved with the funding.
Indianapolis’ budget provides mission statements, allocations by outcome objectives, and comparative performance measures.
State governments are also using these tools. Missouri, Texas, Louisiana and Virginia use performance information extensively in the central budget office, while most States use performance information at the agency level.
Successful implementation of performance-based budgeting has not been limited to this country. Over the past two decades,
every year an increasing number of the 30 countries in the Organization for Economic Cooperation and Development are adopting a performance-based approach to management. New Zealand focused on ‘‘buying outputs’’ ten years ago. Australia and
the United Kingdom are the leaders in focusing on outcomes. Canada and the Netherlands are close behind, with France
and Japan still in the early phases of transforming to an outcome-focused approach.
Australia develops effectiveness and efficiency outputs for its outcomes, and prices each output. The British system is more
structured than Australia, employing performance service agreements, aim (or mission) statements, overarching objectives, performance targets, and statements of responsibility for delivery (achieving the targets). In linking resources with outcomes, the
British Cabinet Committee’s annual budget review allocates monies three years forward, making decisions on both broad outcome levels and the resources needed to achieve the outcome levels.

BUDGETING FOR RESULTS
Testifying before Congress last May, the Director of
OMB signaled his intention to focus on performance.
‘‘Our main focus of the next months will be working
toward full integration of budget and performance information, and using performance data to help make program and budget decisions.’’ He described three specific
steps in this direction.
• ‘‘First, we will insist that agencies develop a credible linkage between resources and performance.
We need to be able to answer the question: ‘What
are we getting for what we are spending?’ As we
work to establish this linkage, we expect to make
some changes to the traditional process of how
we review budget requests, and the nature of our
passback to the agencies on their requests.
• ‘‘Second, we intend to improve our ability to understand the true cost of each program. Full costing of certain program budget accounts will necessitate significant accounting changes, and we are
developing a legislative proposal permitting us to
assign currently unallocated costs and present
these in the budget.
• ‘‘Third, you should see a more robust presentation
of performance information in the FY 2003 President’s Budget. We also intend to explore how a
significant restructuring of the budget document

itself might enhance public and Congressional understanding of government performance.’’
‘‘Work is already underway on these and several related initiatives. These tasks will engage nearly every
OMB office, and will comprise a significant part of the
workload over the next year.’’ The Director concluded:
‘‘We believe that this work will lead to a big potential
payoff in improved effectiveness and efficiency of government.’’
OMB staff and agencies collected evaluations, studies,
and performance documentation of all sorts from all
sources to assess which programs were effectively improving desired outcomes. Within the Executive Branch,
preliminary assessments of these materials were discussed, and agencies were urged to improve program
performance and to improve evidence of effectiveness
and linkage with program cost.
Below are some of the results of this performanceoriented process of policy development and budget allocation. The examples illuminate ways in which policy
makers and program managers can help government
better serve its citizens. Deliberately, they are chosen
to represent ‘‘best practice’’—examples from which other
program managers and policy makers can learn. They
are presented in five categories: (1) funding effective
programs, which have demonstrated benefits greater
than cost; (2) shifting resources toward more effective

5

1. BUDGET AND PERFORMANCE INTEGRATION

programs from less effective ones that have similar purposes; (3) setting program targets and strategies based
on understanding performance and cost relationships;
(4) adding incentives to enhance program effectiveness;
and (5) improving efficiency in programs and support
services.
Funding Effective Programs
Programs in this category are effective. They deliver
real benefits for Americans—healthier babies and families, more disadvantaged youths off drugs and in school
or job training, and advancing knowledge that can improve health and sustain economic growth. These programs have undergone evaluation, not only documenting their effectiveness, but developing understanding of the reasons for their success so that policy
makers and program managers can sustain and build
on it.
• Agriculture: Numerous government and private
studies show that the Special Supplemental Nutrition Program for Women, Infants and Children
(WIC) is one of the nation’s most successful and
cost-effective early intervention programs. The
program saves lives and improves the health of
women, infants and children who are nutritionally
at risk. The Budget reflects this demonstrated success by fully funding the program in 2003 to enable all eligible persons who seek services to receive them. The request is sufficient to provide
7.8 million persons with supplemental foods, nutrition education, and preventive health care each
month in 2003. A contingency fund is available
to serve an expanded number should that be necessary.
• Commerce: Although the U.S. gross domestic
product (GDP) statistics are widely regarded as
among the best in the world, they require continual improvement to keep pace with the nation’s
rapidly changing economy. Additional funding is
proposed for the Bureau of Economic Analysis to
improve and speed production of its statistics, on
which government and business decision-makers
depend.
• Health and Human Services: Community
Health Centers provide high-quality health care
that reduces hospitalizations and emergency room
use, and prevents expensive chronic disease and
disability. The Budget expands the number of centers by 1,200 to serve an additional 6.1 million
patients by 2006. Together with the National
Health Service Corps, the Centers increase the
number of health care providers in underserved
areas.
• Health and Human Services: The 1997 National Treatment Improvement Evaluation Study
found that treatment decreased primary drug use
by 48 percent, alcohol and drug-related medical
visits by 53 percent, and criminal activity by as
much as 80 percent. Welfare dependency, and

homelessness also declined. The Budget supports
an additional 52,000 drug treatment slots.
• Health and Human Services: Funding for the
National Institutes of Health, the world’s leading
research institution for biomedical and behavioral
research, will increase to double its 1998 level.
NIH conducts research in its own laboratories, but
the vast majority of its funding supports researchers in universities, hospitals, and research institutes around the country through peer-reviewed
grants. NIH has supported great advances in the
detection and treatment of disease, and its recent
work on the human genome, cancer, and many
other diseases gives promise of accelerating breakthroughs.
• Labor: The Budget will support four more Job
Corps centers for residential vocational training
for disadvantaged youth than in 2001. At a unit
cost of roughly $31,700 per service year, the Job
Corps is the Department of Labor’s costliest training program. However, evaluations have demonstrated that its benefits exceed its costs. Job
Corps participants get jobs, keep them, and increase earnings over their lifetimes.
• National Science Foundation: The NSF, a leader among Federal agencies that fund basic research, will get more funding and programs transferred from other agencies. Of NSF’s grants, 94
percent are competitive, based on merit review.
Each year, one-third of NSF’s research and educational programs are evaluated for integrity, efficiency, and quality of results, so that all programs
are reviewed in a three-year period. Of the dozen
2001 Nobel prize winners in the sciences, NSF
supported eight for the research that won them
the award. NSF quickly redirects resources to
areas of emerging opportunity, and invests onequarter of its research budget in areas where
major breakthroughs are likely.
Shifting Resources toward More Effective
Programs
Comparison of programs for similar purposes can lead
to the conclusion that some are more effective than
others. Shifting resources toward the better programs
is one way to improve results, while the other programs
seek ways to focus or reform their efforts.
• Commerce: Funding for technology innovation in
the Department of Commerce was increased for
the National Institute of Standards and Technology, a world leader in high-tech and basic industrial standards including work that led to the
2001 Nobel Prize in physics. The Patent and
Trademark Office will also have more resources
and set targets for faster patent and trademark
processing. The Budget channels resources to
higher performing programs by reducing funding
for Manufacturing Extension Partnerships and the
Advanced Technology Program, and terminating
the Technology Opportunities Program.

6

ANALYTICAL PERSPECTIVES

• Housing and Urban Development: Housing
vouchers are lower in cost per unit, at only 85
percent of the cost of Public Housing, and benefits
are higher. More voucher recipients (26 percent)
than Public Housing dwellers (8 percent) live in
census tracts with less than 10 percent poverty;
evaluations are finding better educational, social
and behavioral outcomes from the greater opportunities available in these neighborhoods. The Budget increases funding for housing vouchers, expands
opportunities for families to choose housing that
best fits their needs, and provides more help to
see that vouchers are used effectively.
• Labor/Training: This Budget begins a wide-ranging reform of Federal investments in training and
employment. In 2002, there are at least 48 overlapping training and employment programs scattered around 10 agencies. For several programs
that are duplicative or have a history of poor performance, funding is reduced or terminated, reducing the number of programs from 48 to 28. For
the many other training programs where performance measures are inadequate or not comparable,
a multi-year effort will begin to assess relative
effectiveness, shift resources to programs that
prove effective, and eliminate ineffective or duplicative programs.
• Labor: The backlog of the H1-B visa program will
be eliminated by shifting funds from an ineffective
grant program, and reforming the visa review
process.
• Research: Rigorous peer review of proposals for
research is an effective tool in selecting projects
that are most likely to yield useful results. The
Budget more than doubles funding for USDA’s National Research Initiative, and reduces other agricultural research, in an effort to increase peer review. Also to promote merit-based competition,
NOAA’s Sea Grant program, and the Interior Department’s toxic substances hydrology program
will move to NSF.
• Corps of Engineers: For the Corps navigation
program, the Budget funds improvements for
those waterways with the greatest economic return, and limits funding for those with little commercial traffic.
Setting Program Targets and Strategies
As programs learn to link performance and cost, they
can set targets in their annual performance plan in
line with their budget request. This helps to gain support for their request and holds them accountable to
achieve the targets. Understanding relationships between cost and performance helps to achieve better performance, to gauge the additional cost of additional performance, and, in some programs, to set appropriate
fees.
• Commerce: The National Weather Service, an effective program, got an increase in funding and
specific targets to increase hurricane warning lead

•

•
•

•

•

•

time two hours by 2005, double tornado lead time
to 22 minutes by 2015, improve aviation forecasting accuracy by 13 percentage points by 2007,
and improve temperature and river forecasts for
a pilot region by 2004. Lives will be saved by
more timely evacuations; airline and energy industry costs and energy use will be reduced.
Health and Human Services: The Food and
Drug Administration plans to increase the speed
of processing generic drug applications to act on
75 percent within six months of receipt in 2003,
up from 50 percent in 2001. FDA will also triple
inspections of foods it regulates that are imported
into the United States.
Housing and Urban Development: HUD has set
a target to raise the minority homeownership rate
to 50 percent in 2003.
Justice: The Budget supports a six-month standard for processing all immigration applications.
The Immigration and Naturalization Service will
streamline and redesign its entire process, improving efficiency to reach this target. This will be
done with a clear focus on thorough and timely
screening of all applicants to ensure security. Justice has also set targets for immigration enforcement, prison crowding, and detention cost and
quality.
Social Security Administration: SSA has targeted an increase in retirement claims processed
within 14 days from 84 percent in 2001 to 87
percent by 2003, an increase in customer initiated
services available electronically from 21 percent
to 40 percent; and an increase in callers access
to SSA’s 800 number within five minutes of their
first attempt from 92 percent in 2001 to 94 percent in 2003.
Transportation: DoT manages programs to improve safety in all modes. They have set targets
to reduce the number of serious airport runway
incursions from the 52 last year. The Department
also hopes to reduce highway fatalities and injuries by increasing seat belt usage to 90 percent
by 2005, and reducing alcohol-related fatalities to
11,000 by 2005.
USAID: The Budget increases funding for global
efforts to combat HIV/AIDS. A rapid scaling up
of the program will focus on four countries (Cambodia, Kenya, Uganda, and Zambia) to reduce HIV
prevalence in young adults by 30 percent, increase
the proportion of infected, pregnant women getting
antiretrovirals
to
prevent
mother-to-child
transmision to 7 percent, and increase the percentage of orphans receiving community services
to 12 percent.
Adding Incentives to Enhance Program
Effectiveness

Even effective programs can further enhance their
results by adding incentives for grantees, contractors,
and employees. For less effective programs, this could

1. BUDGET AND PERFORMANCE INTEGRATION

provide a crucial boost to the search for innovation,
efficiency, and new strategies.
• Agriculture: The Food Stamp quality control system measures how accurately States determine
Food Stamp eligibility and calculate benefits.
While the system is necessary to ensure program
integrity, the current system’s sole focus on payment accuracy does not recognize State efforts to
achieve other important program goals, such as
promoting access among working households. As
part of Food Stamp reauthorization, the President
proposes rigorous, but fair, reforms to the quality
control system and performance bonuses for payment accuracy and customer service.
• Commerce: The Administration will propose that
reauthorization of the principal legislation governing marine fisheries conservation enable the
use of transferable fishing quotas in appropriate
circumstances. This strategy can improve economic incentives for fishing investment and activity, which help both profitability and environmental sustainability. Currently, 20 percent of
major marine fish stocks are over fished and another large fraction has unknown population status.
• Education: Vocational Rehabilitation State
Grants are already rated effective, but States vary
widely. As part of the initiative to integrate performance measures and budget decisions, companion Incentive Grants will be allocated to States
based on their performance in helping individuals
with disabilities obtain competitive employment.
• Energy: The Power Marketing Administrations
provide an unusual example of improved incentives. PMAs receive their power from hydroelectric
dams operated by the Corps of Engineers and the
Bureau of Reclamation. In 2003, three additional
PMAs will join Bonneville Power Administration
in directly paying the Corps’ operating and maintenance expenses, permitting the PMAs to negotiate directly with the Corps over their maintenance and upgrades.
• Health and Human Services: The effective Temporary Assistance for Needy Families (TANF) program began in 1996. TANF includes a system of
high performance bonuses to reward States that
have excelled in a variety of areas, including employment outcomes and continued access to benefits. The bonus to reward States with a reduction
in out-of-wedlock births is less effective and so
is being eliminated, with the funds redirected to
develop new approaches to reduce illegitimacy and
promote family formation.
• Labor: The Federal Employees’ Compensation Act
will charge agencies for the full cost of FECA administration as well as workers’ benefits, and will
implement a number of reforms to strengthen program integrity, discourage frivolous claims, and
promote benefit equity.

7
• State: OMB and the State Department are coordinating an effort to right size the government’s
overseas presence. Information is being developed
on how many employees from which agencies are
stationed overseas and what they are doing. OMB
and the State Department are developing a proposal whereby the many agencies that the State
Department hosts will be charged for the full cost
of the space and services that they use, providing
a new incentive to balance cost against the benefit
of overseas presence.
• Treasury: The United States proposes to negotiate a significant increase in the level of assistance provided to the poorest countries as grants
rather than loans. The U.S. will focus this aid
on countries with sound policy environments and
demonstrated performance, and on operations that
raise productivity. The institutions which distribute the aid will be asked to develop reliable
performance and output indicators. The U.S. will
increase its contributions in 2004 and 2005 conditional on specific actions and the achievement of
results.
Improving Efficiency in Programs and Support
Services
If the Federal role is appropriate and the program
is effective or undergoing reform, then attention turns
to the most efficient way to produce outputs. This is
more difficult than in the private sector, where market
price summarizes the value of the timeliness, accuracy,
quality, and other characteristics of outputs. But attention to efficiency can result in the public getting more
government services at the same or less cost.
• Agriculture: The Farm Service Agency and the
Natural Resources Conservation Agency will work
to reduce the reporting burden of the farmers they
serve by 10 percent, and to increase the technical
assistance to priority locations and the eligibility
determinations they provide, while reducing cost.
• Agriculture: Rural Development has had considerable success centralizing loan servicing through
a single, national office and information system.
The Budget proposes that the Farm Service Agency emulate that success by establishing a service
center to centralize farm loan servicing.
• Defense and Veterans Affairs: To increase the
cost-effectiveness of providing medical care, the
Department of Defense and the Department of
Veterans Affairs will begin to coordinate with each
other. They will share information to speed delivery of health services and ensure the safety of
veterans who get care from both DoD and VA.
They will also share resources instead of constructing new facilities, purchase supplies together, and coordinate patient transportation.
• Education: The Department of Education will reform the process of collecting Federal elementary
and secondary education information from States
in order to reduce administrative burden, maxi-

8

ANALYTICAL PERSPECTIVES

mize the usefulness of data, and improve accountability for results. This reform will permit staff
to focus on results, thereby releasing the Department from a culture of compliance and shifting
to a culture of accountability.
• Education: The Department of Education’s costs
for administering student financial assistance programs will be consolidated in a single discretionary account. Requests will be tied to unit cost
targets for major tasks, such as applications processing, loan origination, and loan servicing, and
to annual estimates of participation in various
programs. These changes will enable the Department to measure its progress in meeting productivity and cost-efficiency goals.
• Health and Human Services: HHS is a manylayered bureaucracy with 40 Human Resources offices competing for recruits, more than 50 Public
Affairs offices, and more than 20 Legislative Affairs offices. These will be consolidated into four
Human Resources offices and one each for Public
Affairs and Legislative Affairs. Three building
maintenance and construction offices will be consolidated into one this year, and two more will
be folded in next year, in order to concentrate

expertise and set priorities for capital projects
across the Department.
• Justice: To use detention space efficiently, the
Department of Justice will create a National
Clearinghouse for Detention Space; State, local,
and private providers will electronically post vacancies, rates, services, and other data. Justice
will also explore purchasing private prisons.
• Labor: DoL is providing focused compliance assistance to help employers prevent labor law violations or correct them voluntarily. Efforts include
making the rules more understandable, posting
them on the Web, providing on-site consultations,
and developing interactive electronic tools to help
employers and others understand occupational
safety and health regulations.
These examples show that there are Federal programs with documented effectiveness. These programs
attract support in the President’s Budget. They show
that making decisions based even on today’s rough performance measures can improve results—by allocating
resources to more effective programs, stimulating program reforms, providing constructive incentives, and
cultivating good program management. The integration
of performance measures in the budget process encourages their use in making decisions that improve results.

FOUNDATION FOR RESULTS
Measurement leads to improvement, but it is hard
to find good measures in the Federal government. For
instance, currently many program managers cannot get
a consistent, full measure of the costs of their programs
from agency budget systems. Frequently they do not
actively participate in developing performance measures for the performance plans required under the Government Performance and Results Act (GPRA). The
goal of the Integration Initiative is to give program
managers better information on costs, involve them in
a process of setting goals that are commensurate with
the resources requested, and then hold them accountable for results.
In the same vein, while some agencies have made
good progress in performance reporting under GPRA,
a lot more needs to be done. Even information about
the relationship of existing performance measures to
the budget costs for specific programs is frequently not
available for decision-makers and the public. This Administration has devoted substantial time and effort
over the past year to integrating goals and costs, including making major changes in the budget volume.
Notwithstanding this effort, it continues to be difficult
to systematically assess either the effectiveness of programs, or their relative efficiency when compared to
like activities in other areas of government and the
private sector.
This lack of full, consistent information is the result
of long standing barriers in agency organizations and
reporting systems, some of which are built into law.

To just begin to correct these deficiencies, the following
steps are needed:
• The government’s program managers must participate in the development of broad objectives and
annual performance goals, and link those objectives and goals to an annual budget request.
• Agency reporting systems must be able to report
on these goals, objectives, and costs in an integrated information system that can be aggregated
into the President’s Budget request and the agency budget justification that is transmitted to the
Congress. Agency reporting systems must also
provide acceptable after-the-fact evaluation and financial information on how well goals and costs
have been achieved.
Making results the focus of the budget requires three
significant changes. First, planning and evaluation—
both oriented toward outcomes—must be thoroughly integrated into the budget process and documents. Second, the alignment of budget accounts—and especially
their subdivision into ‘‘program activities’’—should be
reviewed so that the budget can readily relate resources
used to the results produced, and so that good management is supported. This can be done separately for each
agency. Third, accounts and activities should be
charged consistently for the full annual cost of the resources used. This requires legislation.
In October, the Administration transmitted legislation to the Congress to charge the employer’s share
of the full accruing cost of retirement benefits to Federal employers. A companion bill to complete full charg-

1. BUDGET AND PERFORMANCE INTEGRATION

ing for other resources used to produce outputs is being
developed for transmittal following this Budget. Together, these changes are important steps toward a
more results-oriented government.
The broad objectives of the Integration Initiative are
clear enough, but, as with performance measurement
in general, translating these objectives into specific
goals and making the changes necessary to meet the
goals is much harder and takes a long time. Many
program managers, budget officers, performance measurement staff, and other government officials are struggling with this translation.
Integrating the Process
The first step in infusing planning and evaluation
into budgeting is to produce greater collaboration. Some
agencies report that these functions are already carried
out by ‘‘the same’’ staff, and others are considering
mergers. So far, the results of collaboration are usually
more evident at the bureau than at the departmental
level. Planning is more likely to precede budgeting at
bureaus, and a crosswalk between performance goals
and budget cost is often provided.
The Environmental Protection Agency is an example
of an agency that has made substantial progress. It
has an integrated staff to create the budget, set output
targets, and evaluate implementation. Another useful
practice is followed by Health and Human Services,
which holds a department-level joint plan and budget
review for each of its operating divisions to prepare
for the Secretary’s budget submission to OMB.
The second step is to make a serious commitment
to outcomes—and to evaluation of relevant programs
to understand how outcomes can be improved. A results-oriented budget starts from the agency’s strategic
plan and its priorities. What outcomes will the agency
espouse? How do its programs and activities help to
achieve each outcome? Targeting an outcome, which the
agency may influence but cannot control, seems risky.
Yet without a serious commitment to outcomes, the
agency’s programs may be efficient—but only accidentally will they be effective. Moreover, agencies without

9
this commitment are likely to have so many ‘‘performance measures’’ that few capture attention, get agency
priority, or aggregate into results that the public cares
about. Below are two examples of outcomes related to
agency outputs. Note in the first example how an outcome—highway safety—may be produced by the outputs of several different agency programs and activities
taken together.
• Transportation. To reduce highway fatality and
injury rates, DOT will test automobiles to ensure
compliance with safety standards; promulgate new
or revised safety standards in several areas; invest
in infrastructure improvements to reduce conditions or factors most associated with highway fatalities, such as single vehicle run-off-the-road
crashes (which cause 38 percent of all deaths);
and increase research into how the growing levels
of driver distractions may increase accident rates.
• Veterans Affairs. To improve the overall health
of veterans through high-quality, safe, and reliable
health services (an outcome), VA has sharply increased its score on the Care Index (a measure
of the degree to which VA follows nationally recognized guidelines for the treatment and care of patients with one or more of five major ailments)
and on the Prevention Index (a measure of the
degree to which VA follows nationally recognized
prevention and early detection recommendations
for eight diseases or health-risk factors).
Finally, a single streamlined, integrated plan-andbudget document should eventually be produced. So far,
agencies have included budget amounts in their annual
performance plan, first at an aggregate level and then
in more detail. They have also included performance
measures in their budget justifications, sometimes
linked with program resources. Plans are relatively
streamlined; budgets rarely are—not even in the sense
of a streamlined overview with supplementary volumes.
The Department of Labor and some other agencies are
working toward a single integrated document. But few
have learned a lesson from great chefs: ‘‘reductions’’
take more time, but they have more flavor!

10

ANALYTICAL PERSPECTIVES

Chart 1-1. Linking Resources with Results
Outputs
Inputs
Financing sources

Outcomes
Net impacts

Program managers with authority over budgetary
resources and staff offices are charged for the full
annual cost of resources used and are responsible
for efficient production of related outputs.
Evaluation determines which outputs with which
characteristics do most to improve the desired
outcomes. Several programs may influence a single
outcome.

Improving Alignment
Account and activity alignment should eventually fit
the nature of each agency and bureau. Alignment needs
to be considered with care. Consideration might begin
with the question: What general principles for alignment contribute to creation of a results-focused budget?
Attention naturally turns to programs for the public
that carry out the agency’s mission. The agency’s Strategic Plan, which is based on its authorizing legislation
and involves wide consultation, is a potential starting
point for identifying strategic goals and the outcomes
that the agency seeks to improve. If the agency’s perspective or environment have changed enough to affect
its strategic goals (e.g., the Department of Justice after
September 11th), they need to be brought up to date.
The agency’s main goals could be listed, along with
the outcomes that measure success in achieving each.
This could provide an organizing framework for the
integrated plan and budget document.
The traditional—indeed Constitutional—purpose of
the budget accounts is to control budgetary resources.
That emphasis will continue, and no changes in budget
concepts or total budget outlays are proposed as part
of the Budget and Performance Integration Initiative.
But the account structure needs review to ensure that
it supports, or at least does not hinder, good management. From that perspective, all of the resources used
by a bureau or other organization should be financed

from one or more budget accounts associated with it.
At an aggregate level, resources would be managed by
those accountable for achieving results.
Bureaus are clearly visible in the budget account
structure of almost all Departments. Many accounts
finance an entire bureau or office. Where there are
more accounts, there is often a good managerial reason:
a major program may have an account of its own; large
mandatory transfers or grants may be in a separate
account from administration and other complementary
discretionary activities; if the bureau conducts programs and activities for very different major purposes,
separate accounts may support better decisions. But
multiple small accounts for similar purposes are usually
unnecessary. And multiple accounts for different inputs
or different activities leading to the same output or
outcome may inhibit a manager striving for the best
results. Some account consolidation might be useful.
The ‘‘program activity’’ sections that subdivide budget
accounts offer an opportunity to improve linkage between resources and results. In accounts that finance
provision of goods, services, grants, transfers, credit,
insurance, or regulation for the public, program activities could align the resources used with the results
achieved—usually an output for the public, such as
loans made—with related performance measures that
influence desired outcomes, such as the percent of loans
made to first-time homeowners and the percent that

11

1. BUDGET AND PERFORMANCE INTEGRATION

remain in payment status. This is sometimes current
practice. But in other cases, these subdivisions may
show inputs, some-but-not-all of the funding for an output, or an intermediate process that contributes to sev-

eral outputs. Such practices make it difficult to show
the full annual cost of resources used to achieve specific
results. They also splinter responsibility for achieving
results that Americans value.

Immigration and Naturalization Service Program and Account Restructuring
In 2003, the Administration is proposing a realignment of the Immigration and Naturalization Service’s (INS’s) account structure. In the past, INS had three accounts: salaries and expenses, construction, and immigration support. A person looking at
the INS accounts could not determine how much money was spent on immigration enforcement or immigration services.
Even looking at various fee accounts, one could not see how much of the money collected from application fees went to
processing the application versus enforcing immigration law. The new structure provides the full picture of how much money
collected from application fees went to processing the application versus enforcing immigration law. The new structure provides the full picture of how much money is spent to fulfill the agency’s dual missions of enforcement and services.
This proposal realigns the INS budget and account structure with the Department of Justice’s and INS’s Strategic Plan objectives, making it easier to track resources with results. It not only changes the account structure but also collapses the
current program structure from 13 different programs to six programs that directly link to performance objectives. It organizes similar enforcement actions together and clearly separates immigration services and support operations. The support
and administration account is temporary, capturing the overhead and support costs that could not be easily spread in the
first year. INS plans to spread these costs in the 2004 budget. This will complete the realignment of funding to allow for
linking funding with performance goals—so the public knows what it is getting for its money.

Chart 1-2. INS Program & Account Structure Linked to
Performance Objectives
Current Program Structure

New Program Structure

New Account Structure

Performance Objectives

Border Patrol
Inspections

Border Enforcement

International Affairs
Enforcement

Intelligence

Interior Enforcement

Investigations

Detention &
Removals

Immigration Services
International Affairs
Benefits

Data and
Communications

Training

Management and
Administration

Immigration
Services
Account

OBJECTIVE: Deliver services
to the public in a professional and
courteous manner and ensure
that correct immigration benefit
decisions are made in a timely
and consistent fashion.

Support
and
Administration

OBJECTIVE: Strengthen
human resource recruitment and
retention efforts and provide for a
workforce that is skilled, diverse,
and committed to excellence.

Information Resource
Management

Construction and
Engineering

Legal Proceedings

OBJECTIVE: Facilitate lawful
travel and commerce across the
borders of the U.S.

Detention & Removals

Adjudications and
Naturalization

Information and
Records
Management

Immigration
Enforcement
Account

OBJECTIVE: Secure the ports
of entry, land border, and coasts
of the U.S. against unlawful
entry.

Infrastructure and
Administrative Support

12

ANALYTICAL PERSPECTIVES

Thoughtful long-term reforms are needed in budgetary structure to manage for results. The Federal
Aviation Administration is improving its budget accounts for capital and research by aligning funds under
performance outcome goals. The agency is also streamlining these accounts to increase managerial flexibility
to achieve performance outcomes. A more extensive example of an agency working on this problem is the
Immigration and Naturalization Service. The presentation on the previous page shows their prior account
structure, how they transformed it, and how it lines
up with INS’s performance objectives.
Charging Full Annual Budgetary Cost
To show the full annual budgetary cost consistently
across all programs requires more than improving account and activity alignment. It also requires providing
budget authority to cover the resources used for each
program and oversight account, and charging all accounts for the full annual cost of using resources. Currently this is not systematically done.
• Civilian retiree health benefits have all been paid
centrally for the whole government; military
health benefits have been paid centrally by DoD
and the small uniformed services. Costs are not
shown when the benefits are earned; only when
they are paid.
• Pensions for new civilian employees and for military employees were reformed in the mid-1980s,
with employers paying their share of the accruing
cost. But costs for employees hired earlier under
the Civil Service Retirement System are only partly charged, and several small systems are payas-you-go, which creates an uneven effect across
programs.
• Support goods and services are often paid centrally by agencies or provided to programs at less
than full cost. There are indications that programs
use different amounts and kinds of support in
these circumstances than when they pay full cost.
In other instances, agencies may allocate cost to
the programs, leaving managers feeling burdened.
• Capital costs are most problematic. From the program manager’s perspective, they may be zero if
financed centrally, some share of acquisition cost
if that is allocated, the rental value if office space
is rented from GSA, or a substantial bite out of
their budget for a rare capital acquisition.
In sum, program costs are often lower than annual
operating costs—by widely varying amounts—and
sometimes higher. The Budget and Performance Integration Initiative will improve on this and begin to
create more complete and uniform measures of annual
budgetary cost across the government. That will begin
to permit the fair comparison of the cost of one program
with another.
Two complementary legislative proposals—one already transmitted to the Congress and the other under
development—would apply ‘‘best practice’’ consistently

to show a more complete measure of budgetary cost
where and when resources are used.
• To show resources where they are used, the second proposal would include a straightforward but
powerful requirement: the full annual budgetary
cost of resources used by programs shall be
charged to the budget account or accounts that
fund the program. More than one program might
be funded by a single account so long as the
amounts used are separately distinguished. These
provisions would be deliberately general, leaving
how they would be applied to case-by-case decisions on alignment.
• To show support services where they are used,
the second proposal would create intra-governmental support revolving funds (ISRFs) from
working capital, franchise, and other support revolving funds. Any support goods and services provided to more than one bureau would move into
an existing fund or a newly created one. Like all
other accounts, ISRFs would be charged for the
resources they use and would charge programs
and other customers enough to operate on a selfsustaining basis.
Three other provisions of legislation would use pairs
of budget accounts to change when costs are shown
in the program accounts without changing the timing
for the budget totals. These cover all major cases where
resources are used long before or long after they are
paid for.
• Pensions and retiree health benefits are earned
as Federal employees work; they are paid much
later, after the employees retire. The legislation
already transmitted would require program and
other employer accounts to pay the employer
share of the accruing cost of these benefits to retiree benefit accounts, where they are offsetting
collections. These accounts would pay the benefits
when they come due.
• Similarly, programs that generate hazardous substances would be required to pay the accruing cost
to clean up contaminated assets at the end of
their useful life. These payments would go to
funds responsible for the cleanup.
• In contrast, capital assets are bought before they
are used. In this case, an agency Capital Acquisition Fund (CAF) would be created. Following good
budget practice, the CAF would request budget
authority (BA) up front to acquire assets that are
included in the budget, and outlays would be recorded when payment was made. However, this
BA would be in the form of borrowing from Treasury authority. The CAF would then borrow for
the period of the asset’s useful life; collect annual
capital user charges in proportion to asset use,
and make the mortgage payments to Treasury.
The General Accounting Office supported these concepts for budgeting in the United States in a recent
report, Accrual Budgeting: Experiences of Other Nations
and Implications for the United States. (February 2000).

13

1. BUDGET AND PERFORMANCE INTEGRATION

Full Funding for Federal Retiree Costs. To make
quick progress on these practices, the Administration
split the required legislation into two parts. In October,
the first bill—‘‘Budgeting and Managing for Results:
Full Funding of Retiree Costs Act of 2001’’—was transmitted to Congress as Title II of the Managerial Flexibility Act of 2001.
The proposal charges to salary and expense accounts
in all Federal agencies—most of which are funded by
discretionary appropriations—the employer’s share of
the full annual accruing cost of retirement benefits
above and beyond the amounts that are charged now.
The bill requires charges for:
• the full accruing cost of the Civil Service Retirement System and the parallel Foreign Service and
CIA pensions,
• retired pay for the small uniformed services (Coast
Guard, Public Health Service, and NOAA),
• retiree health benefits for civilian employees in
the Federal Employee Health Benefit Program,
and
• retiree health benefits for the seven uniformed
services. For the latter, accrual of health benefits
for those 65 and over will start in 2003 under
existing law, and accrual of benefits for younger
retirees is proposed to start in 2004.
Existing liabilities are amortized by mandatory payments from the general fund, and benefit payments
are mandatory.
This component of cost was proposed first because
it could be implemented largely by changing the
amounts paid from and to existing accounts. These
costs are displayed by account in the 2003 Budget for
2003 and beyond, with comparable estimates published
for 2001 and 2002.
The bill does not change total budget outlays or the
surplus/deficit; it shifts costs from central mandatory
accounts to increase the affected discretionary accounts
on the civilian side by $9.2 billion. The additional discretionary amounts were treated as an adjustment in
this Budget.
Thus, the Budget requests sufficient funding by account for this conceptual change, except for programs
that are funded by user fees. Under OMB Circular
A–25, the costs of the latter programs are expected
to be covered by their fees. The adjustment for accounts
producing support goods and services is made in their
customers’ budget accounts.
This legislation would fully fund the employer share
of all Federal pensions, retired pay, and retiree health
benefits by agency payments to the retiree benefit funds
each year as they are earned by employees. It would
amortize past unfunded liabilities on a regular schedule
by payments from Treasury to the retiree benefit funds.

The legislative language requires the appropriate
amounts to be paid out of all salary and expense appropriations, just as they are now for the Federal Employee Retirement System (FERS) and the Military Retirement System (MRS).
These charging practices would go a long way to close
the gap between current budgetary cost and uniform
full operating cost so that cost and results can be compared with each other and across programs.
The bill would not change the government cost that
would be compared with private offers in a public private competition. These costs are already included in
the OMB Circular A–76 comparison. But it moves toward the possibility of fair competition without the current burdensome process.
Full Budgetary Cost and Performance Integration. As discussed above, the Administration is developing a second proposal to charge uniformly for other
resources where and when they are used. It is intended
for transmission to Congress after this Budget. Implementation would start in the fiscal year 2004 Budget,
but with additional implementation in future years.
This proposal covers the 24 CFO Act agencies, except
that the Director of OMB may extend the support goods
and services provisions to other agencies.
While still under review, this proposal’s key goal is
to facilitate the full annual budgetary cost of resources
used by programs being charged to the budget account
or accounts that fund the program. More than one program may be funded by a single account so long as
the amounts used are separately distinguished. How
this is worked out in each agency—and how closely
it hews to the spirit of aligning costs with outputs and
outcomes—will determine where the costs defined in
the other provisions will be charged. To retain the current degree of flexibility to deal with changing circumstances, the proposal will include limited transfer
authority.
None of the budgetary changes in this proposal will
affect the ‘‘bottom line’’ of the budget as a whole, or
the basic budgetary concepts of budget authority, obligations, and outlays. They do increase the amount of
discretionary budget authority that must be appropriated to capture the full cost of programs. The effect
of this will be that programs that produce outputs for
the public will recognize discretionary spending in the
budget at the time when they incur costs.
Therefore, for each program, the budget account
would show the total budgetary resources used to pay
annual operating cost. Comparison of resources and results will be systematic when allocating resources; and
managers will have timely feedback and better resource
control with which to achieve better results.

MANAGING FOR RESULTS
What you measure is what you get. The greatest
initial impact from integrating performance and budgeting is that we will begin to get better results for

each budget dollar. In the slightly longer run, managing
for results will continually improve program outcomes.
The President’s Management Agenda launched this ef-

14

ANALYTICAL PERSPECTIVES

fort last August. The Agenda includes five governmentwide initiatives that are intended to work together as
a mutually reinforcing set of reforms. In addition to
Budget and Performance Integration, they are Strategic
Management of Human Capital; Competitive Sourcing;
Expanding Electronic Government; and Improving Financial Performance.
The Strategic Management of Human Capital Initiative will align human resources with programs and
their outputs, so that real as well as budgetary resources will be focused on producing results. The Competitive Sourcing Initiative will give program managers
more choice in the character and cost of the inputs
they buy with the budgetary resources they control.
The Expanding Electronic Government Initiative will
help programs to coordinate and deliver services. And
the Improved Financial Performance Initiative will integrate financial and performance information that, together with Budget and Performance Integration, will
provide timely, analytical feedback to managers. These
Initiatives place more authority and accountability for
outputs at the operating level, use working groups and
intermediate levels of management to coordinate pro-

grams to influence outcomes effectively, and focus top
management on policy development and oversight.
The basic idea is to align authority, staff, and all
resources used with specific bureaus and programs, to
provide flexibility in the use of those resources, and
to hold managers and staff accountable—with rewards
when successful—for achieving agreed-upon results.
Following the spirit of accountability, this Budget is
presented by Agency rather than by cross-cutting functions.
These five government-wide Presidential initiatives
were selected because in each area the Federal Government is operating below potential, yet there is also
a clear path to improvement with a major pay-off at
the end. As a goal post, each of the initiatives included
standards setting forth the characteristics that would
define the success to be achieved over the next three
years. OMB is working with agencies to customize the
progress that each agency should make this year to
achieve full success within three years. Agencies will
earn ‘‘green lights’’ on progress for each quarter in
which they meet the milestones along their agreed
pathway to success.

Chart 1-3. Moving Toward ResultsOriented Government
Results orientation will be infused into every
aspect of government:
Budgeting -- results, targets, and structure
Managing -- in the spotlight
Staffing -- align and empower staff, reward results
Acquisition -- competitive, performance-based
IT -- integrated, timely, delivering service

Reporting -- accurate, timely, and integrated

15

1. BUDGET AND PERFORMANCE INTEGRATION

Strategic Management of Human Capital
A growing portion of the Federal workforce will become eligible to retire over the next decade. Good
human resource management is needed to ensure that
people with the necessary skills are hired, trained, and
retained to provide public services. Human resources,
as well as budgetary resources, need to be aligned with
programs and activities that produce results. Aligned
managers should be delegated the authority they need
to get the job done, including more flexibility to hire
and manage personnel, rather than hampered by excessive layers of review. The Integration and the Human
Capital initiatives both link rewards to individual and
group success in reaching performance goals. Below are
examples of good practice.
• Treasury implemented knowledge management
systems to help preserve and share the experience
and institutional memory of retiring employees.
• The Veterans Affairs Healthcare Network for
Upstate New York involves its employees in developing work unit ‘‘stretch’’ goals at least 10 percent
higher than the consensus expectation for the
amount of work that will be accomplished. Employees have a stake in their success through a
‘‘goal sharing’’ incentive program, where modest
awards are based on reaching goals at the regional
and unit level. Since the program began, the program has reduced cost per patient and improved
customer service and satisfaction.
• The General Services Administration’s Public
Buildings Service allocates regional office budgets
based on nine performance measures. Targets are
set for each measure, and a portion of the Performance Excellence Pool goes to regions for each
goal they exceed. Organizational and individual
performance has improved across the measures,
with lower costs and better efficiency, effectiveness, and customer satisfaction.
Competitive Sourcing
The President’s Management Agenda includes an initiative to acquire an increasing proportion of commercial goods and services through competition among and
between public and private sources. The process, as
defined in OMB Circular No. A–76, relies on a performance-oriented statement of work and a comparison of
the full costs to the taxpayer for each source. Last
March, OMB set a target for agencies to compete or
convert to contract not less than 5 percent of their
FAIR Act inventories of commercial work performed
by Federal employees in 2002. Agencies were asked
to compete an additional 10 percent of their FAIR Act
inventory in 2003. The agencies will retain all of the
savings achieved through Competitive Sourcing.
Innovation and efficiency are stimulated when agencies compete the acquisition of support goods and services from providers in their own agency, other agencies,
or the private sector. Savings are generated which can
be put to use in support of the agency’s mission. The
Department of Defense has competed 218 competitions

since 1955, of which 57 percent were retained in-house,
and 43 percent converted to contract. When retained
in-house, the average savings were 34 percent.
However, OMB Circular A–76 is a cumbersome and
complicated process. It requires developing a performance-based contract, conducting a management study
to design a most-efficient-organization for the in-house
bidders, and making an elaborate cost comparison. The
process needs to be reformed to allow program managers to be free to acquire the support goods and services that best meet their needs.
Expanding Electronic Government
E-government can improve the coordination, efficiency, and effectiveness of delivering information and
services to the public. These projects may bring together programs producing different outputs toward
common outcomes, and help them to deliver services
from the customer’s perspective. In order to make the
government truly ‘‘citizen-centered,’’ agencies will have
to work together around the needs of citizens and businesses—not agency boundaries. Citizen-centered government will use the Internet to give citizens the ability
to go online and interact with their government. Below
are some interesting examples.
• The Department of Commerce is using the Internet to serve businesses interested in international
trade and minority contracting opportunities. Census uses e-government for its economic surveys
of firms, and will use it more for the 2010 census
of population.
• The Department of Labor’s Occupational Safety
and Health Administration accepts health and
safety complaints over the Internet. In addition,
individuals can use the Internet to discover lost
pensions, and a pilot project allows people to calculate their approximate retirement benefits online.
• The National Science Foundation was the first
agency to perform all of its critical interactions
with its proposal applicants through the web. Over
99 percent of the proposals the agency receives
are submitted electronically.
• The Social Security Administration is rapidly expanding online customer service options. These include making retirement claims, receiving Medicare replacement cards, checking account status
on-line, getting access to change one’s address and
telephone number, and making direct deposits.
Improving Financial Management
Financial management is a natural complement to
budgeting. Better account and activity alignment with
performance is needed; resources should be charged
where they are used. This congruence would facilitate
accounting, and the emphasis on performance would
provide incentives for, as well as facilitate, cost accounting. Performance, budgeting, and accounting information potentially could be entered using standard analytical software at the program and activity level, where

16
it would be familiar and used as timely feedback, making it likely to be accurate. All entries should be fully
coded to the Standard General Ledger. The modules
as a whole could then be uploaded and consolidated.
• Transportation is implementing a new Department-wide financial management system that is
geared towards capturing transactions at the
source, automating the matching of expenditures
to the obligating document, and obtaining electronic approvals. By capturing transactions at the
source, this process reduces the likelihood of erroneous payments and posting the charges to the
wrong contract. All organizations in DOT are
working to convert to the new system by the end
of calendar year 2002.
• The Treasury Franchise Fund consists of eleven
‘‘business activities,’’ each with a separate account
established to facilitate financial reporting. Although the audited financial statements of the
Fund are presented on a consolidated basis, its
financial system generates individual financial
statements for each business activity. Revenue
and expense data are recorded and reported by
business line. Direct and indirect costs are identified by each business activity and reported internally on financial reports.
• The Social Security Administration included a
comprehensive footnote disclosure in its Accountability Report that described the method they use
to classify operating expenses by strategic goal.
SSA aligns its strategic goals with its request for
new budget authority as part of its annual budget

ANALYTICAL PERSPECTIVES

request. They applied the same method to allocate
primary administrative expenses to each strategic
goal and reconciled that to the operating costs
reported on the Statement of Net Cost.
• The Department of Education is using activitybased costing in its student financial assistance
(SFA) programs to improve efficiency. SFA has
worked with managers to define program and
business activities, assign cost, and map the activities. A user-friendly reporting tool provides
managers with on-line multidimensional views of
the results. Quarterly management reports are
provided to managers showing the cost of their
business processes and providing insight into the
drivers of those costs. Managers are being assigned cost reduction targets, which this system
and benchmarking with private industry and
other agencies will help them to meet.
• The Environmental Protection Agency provides
integrated financial and programmatic data to the
agency’s managers to support decision-making
based on costs. For example, EPA is tracking the
cost for all major IT projects by phase. Agency
cost accounting for the Superfund program has
resulted in over $2.8 billion in cost recoveries. And
the agency’s accounting structure has been redesigned to provide the costs of achieving the goals,
objectives, and sub-objectives embodied in their
Strategic Plan and budget.
All five of the President’s Initiatives thus contribute
to the performance orientation and effectiveness of the
Federal Government.

ECONOMIC ASSUMPTIONS AND ANALYSES

17

2. ECONOMIC ASSUMPTIONS
Introduction
Beginning in mid-2000, economic growth decelerated
sharply. Over the following half-year manufacturing
production declined, the Nation’s payrolls grew very little, and the unemployment rate rose. In response to
the slowing economy, the Federal Reserve cut the federal funds rate by 2-3⁄4 percentage points during the
first half of 2001, the largest reduction in such a short
period since 1984. Fiscal policy also shifted to stimulate
demand. In June, the President signed the Economic
Growth and Tax Relief Reconciliation Act of 2001,
which reduced personal income taxes by $44 billion during the second half of the year, the first installment
in a multi-year permanent reduction in income tax liabilities.
Under normal circumstances, the strong monetary
and fiscal stimulus either in place or enacted by mid2001 would have been more than sufficient to reinvigorate the stalled economy. In fact, last spring most forecasters, including the Administration, were predicting
that the sluggish growth that began in 2000 would
end by late 2001 and the economy would again be growing at a sustainable pace that would keep the unemployment rate from rising further.
However, the normal channels of transmission linking economic policy and economic performance never
had a chance to operate. The terrorist attacks of September 11th temporarily shattered consumer and business confidence. Faced with a highly uncertain and
much more risky economic environment, consumers,
businesses and investors for a brief time became much
less willing to undertake the purchases and investments which are needed to achieve sustainable growth.
According to the National Bureau of Economic Research (NBER), the business cycle expansion that began
in March 1991 ended in March 2001, six months before
the terrorist attacks. The expansion lasted exactly ten
years, making it the longest period of continuous economic growth in the Nation’s history. In the absence
of the terrorist attacks, the longest-running expansion
might have continued well into its second decade. As
the NBER stated, ‘‘Before the attacks, it is possible
that the decline in the economy would have been too
mild to qualify as a recession. The attacks clearly deepened the contraction and may have been an important
factor in turning the episode into a recession.’’ 1
At the start of 2001, hardly any forecaster expected
that the economy would slip into recession within a
few months. None did, or could, anticipate the shock
to the economy from the terrorist attacks later in the
year. Consequently, forecasts of real GDP growth made
1 National Bureau of Economic Research, ‘‘The NBER’s Business-Cycle Dating Procedure’’,
December 13, 2001, page 7.

in January 2001 turned out to be well above the actual
outcome.
The forecasts made in January 2001 by the Administration, the Congressional Budget Office (CBO) and the
Blue Chip consensus, an average of prominent private
sector forecasts, projected real GDP growth in 2001
would be close to 2.5 percent. Although the official estimate of fourth quarter growth is not yet available, the
consensus forecast anticipates that growth in 2001 will
be close to 1 percent. The error was especially large
for business capital spending. Most forecasters expected
an increase in 2001; instead it fell sharply.
The forecasts made in January 2001 by the Administration, the CBO and the Blue Chip consensus for GDP
growth in 2002 were all close to 3.5 percent. That is
about 2-1⁄2 percentage points above the current projections for 2002, which are 0.7 percent in the economic
assumptions used in this Budget; 0.8 percent in the
January 2002 CBO projections; and 1.0 percent in the
January 2002 Blue Chip consensus.
The large over-estimate of real growth during
2001–2002 contributed to a large over-estimate of receipts in FY 2002. Receipts are now expected to be
$177 billion lower than anticipated in the 2002 Budget
published in April 2001 due to the weaker economy
and related factors, and outlays are expected to be $20
billion higher. Thus, the budget balance for 2002 has
been reduced $197 billion due to the impacts from the
unexpected weak economy. (For further details, see the
section below ‘‘Sources of Change in the Budget Since
Last Year.’’) Economic-driven misses in budget projections are not unusual, however. The budget balances
for 1998 through 2000 were boosted by $135 billion
to $200 billion each year due to economic and technical
factors, relative to the forecast made at the start of
each budget year. (For further discussion of the historical record of misses in budget projections and their
sources, see Chapter 18, ‘‘Comparison of Actual to Estimated Totals for 2001.’’)
Despite the setback caused by the terrorist attacks,
the economy appears to be once again poised to resume
sustainable growth in 2002. The Federal Reserve cut
the Federal funds rate four times after September 11th,
lowering it to just 1-3⁄4 percentage point in early December, the lowest it has been in 40 years. In total during
2001, the Federal Reserve reduced the funds rate by
4-3⁄4 percentage points, which helped support consumer
durables spending and residential investment in 2001
and which will stimulate business investment during
the recovery this year. Inflation remains low, which
will allow the Federal Reserve to ease further if that
appears necessary.
Substantially lower energy prices will provide a boost
to economic activity. Crude oil prices have fallen nearly

19

20
50 percent since late 2000, with an especially sharp
drop after mid-2001. Lower prices for gasoline, heating
oil and natural gas act like a tax cut for energy-consuming households and businesses, although this is
partly offset by lower incomes for domestic energy producers. The net impact is stimulative because the
United States imports a substantial portion of the energy it consumes.
Fiscal policy is also expected to boost growth. The
bipartisan economic security package proposes lower
personal taxes and increases incentives for business investment. These measures, along with the budget’s
‘‘automatic stabilizers’’ such as lower income taxes and
increased unemployment insurance payments, will provide additional purchasing power to households and
businesses this year.
During each quarter of 2001, businesses cut back on
capital spending in response to a ‘‘capital overhang’’
that developed in 2000 following the Y2K surge in
spending, the unanticipated slowing of demand here
and abroad, and the decline in corporate cash flow.
When the economy begins growing again, businesses
will have the willingness and ability to invest more
in new plant and equipment. Also, businesses liquidated inventories during 2001 to such an extent that
they will soon have to step up orders to replenish
stocks. For these reasons, the usual dynamics of the
business cycle are likely soon to swing from restraining
growth to boosting growth. Increased orders for capital
equipment and stockbuilding will require increased production, which will require more workers on payrolls,
which will generate more incomes, restore confidence,
stimulate consumer spending, and, in turn, lead to further increases in business investment. This ‘‘virtuous
circle’’ has been the regular sequence of events in past
business cycles.
Financial markets are already anticipating faster economic growth this year. The stock market is often a
reliable leading signal of future economic activity, and
it has risen sharply from its low point on September
21st. By mid-January, the Dow Jones Industrial Average had gained almost 20 percent and the technologyladen NASDAQ 40 percent. In every post-World War
II recession, the economy has emerged from recession
to expansion a few months after the start of a sustained
stock market rally. Bond markets are sending a similar
signal. The spread between short and long-term interest
rates widened significantly in the final months of 2001,
an indication that bond market investors also anticipate
faster growth shortly.
Despite the encouraging signals from financial and
nonfinancial markets, a strong and sustained expansion
is far from assured. The recovery of business investment may be delayed; consumers may yet curtail discretionary spending in the face of uncertain prospects for
employment and income; and U.S. exports may be
weaker than anticipated as a result of slow growth
abroad. In light of these downside risks that might
prolong the recession, the Administration endorses the

ANALYTICAL PERSPECTIVES

bipartisan economic security package to insure a quick
and successful transition from contraction to expansion.
This chapter begins with a fuller review of recent
economic developments and policy actions. The chapter
goes on to present the Administration’s economic assumptions that underpin the 2003 Budget projections
and to compare these with the forecasts of the private
sector and the Congressional Budget Office. The economic assumptions are conservative and close to those
of the Congressional Budget Office and the consensus
of private sector forecasters, both in the near-term and
over the Budget horizon to 2012. As such, the Administration’s assumptions provide a prudent basis for the
budget balance projections. The following sections of
the chapter describe how the economic assumptions
have been revised since those of the 2002 Budget and
how the changes in economic assumptions, policies and
technical factors since last year have affected projected
budget surpluses. The next section presents cyclical and
structural components of the surplus. The chapter concludes with estimates of the sensitivity of the budget
to changes in economic assumptions.
Recent Developments
The 2000–2001 Economic Slowdown: The slowdown
in the economy’s growth rate began in mid-2000, well
before the onset of the recession in March 2001. During
the second half of 2000, the economy expanded at only
a 1.6 percent annual rate, and during the first half
of 2001 growth slowed further to a mere 0.8 percent
annual pace. A number of factors contributed to the
deceleration of economic activity:
• First, from the end of 1995 through mid-2000 real
GDP growth was at an unsustainably strong pace,
averaging 4.3 percent per year. By mid-2000, it
was clear to most observers that growth would
have to slow for some period of time to permit
the economy to return to its potential level.
• Second, the cost of credit rose during 1999 and
the first half of 2000, as the Federal Reserve tightened monetary policy to avoid an acceleration of
inflation.
• Third, the stock market fell after March 2000,
with an especially pronounced drop for high-tech
firms. The loss in equity wealth slowed the growth
of consumer spending and raised the cost of capital to business. With the benefit of hindsight, it
appears that the stock market at the end of the
1990s had reached unsustainable heights, especially for high-tech firms.
• Fourth, energy prices spiked in 1999 and 2000.
The higher energy prices acted like a tax on consumers, leaving them with less income to spend
on non-energy goods and services. Profits of nonenergy producing businesses were squeezed by the
higher costs of production.
• Finally, by late 2000, businesses found themselves
with excess fixed capital and unwanted inventories. In response, firms sharply reduced business
fixed investment and inventories during 2001.

2. ECONOMIC ASSUMPTIONS

Despite the equity losses, consumer spending continued to sustain the economy’s growth after mid-2000.
Consumer spending adjusted for inflation accounts for
two-thirds of GDP and residential investment another
4 percent. With 70 percent of the economy growing,
albeit at a somewhat slower pace, real GDP continued
to expand slowly through the second quarter of 2001.
Residential investment also expanded during the period
of decelerating GDP growth, spurred by historically low
mortgage interest rates. During 2001, the rate on 30year mortgages averaged 7.0 percent, the lowest level
since the 1960s. Housing starts actually increased after
mid-2000 and total home sales set a record high in
2001.
The business sector was the major source of restraint
responsible for the deceleration of GDP growth. After
eight successive years of double-digit growth, real investment in equipment and software slowed sharply
beginning in the third quarter of 2000, and declined
in each of the next four quarters. The decrease in investment in high-technology equipment was especially
pronounced, but spending on other types of equipment
and structures also declined. As the economy’s growth
slowed, excess capacity emerged in many industries and
reduced the immediate need for new capital investment
to augment capacity. Businesses also sharply reduced
their inventory investment during the second half of
2000 and continued to liquidate inventories in 2001
as they sought to bring stocks back in line with weakened sales. Although inventories are a relatively small
component of GDP, they are subject to substantial
swings that exert a disproportionately large impact on
GDP growth around business cycle turning points.
Since the middle of 2000, declining inventory investment has reduced real GDP growth by between onehalf percentage point and 2-1⁄2 percentage points in
each quarter. Although the official data are not yet
available, inventory liquidation in the fourth quarter
of last year appears to have again reduced real GDP
growth substantially.
Government purchases added a little less than onehalf percentage point to real GDP growth after mid2000. Virtually all of that modest contribution to
growth came from State and local spending; Federal
government spending hardly increased. Net exports also
had only a small impact on GDP growth after mid2000. Growth of U.S. exports was hurt by slow growth
abroad, while the growth of U.S. imports was restrained
by the deceleration of U.S. domestic demand. As a result, the net export balance, which had deteriorated
sharply during the last half of the 1990s, hardly
changed after mid-2000. The unemployment rate began
rising steadily after its cyclical low in October 2000
at 3.9 percent.
Fiscal Policy: In keeping with his campaign pledge,
soon after the President took office in January 2001
he proposed substantial tax relief for the American people. That goal was achieved with the passage of the
Economic Growth and Tax Relief Reconciliation Act
(EGTRRA) in June. The Act, which is projected to re-

21
duce taxes by $1.24 trillion over 11 years, will enable
families to keep more of their income and will provide
new incentives to work and save. The bill reduces marginal income tax rates; reduces the ‘‘marriage penalty’’
for most married couples; increases the child and adoption tax credit credits; eliminates the estate tax; and
increases the annual contribution limits to IRAs, 401k
retirement plans, and educational IRAs. Many of these
tax reductions became effective starting in 2001 or 2002
and were phased in over several years.
The tax reduction package was well timed to support
a weakened economy. Beginning in July of 2001, 85
million taxpayers received rebate checks totaling $36
billion. These checks represented a full year’s tax reduction from the creation of the new 10 percent tax bracket
carved out of the beginning of the 15 percent tax bracket. In addition, beginning July 1st, payroll tax withholding schedules were reduced to reflect the phasein of the lower marginal income tax rates for those
in the 28 percent tax bracket and higher. In January
of this year, payroll withholding schedules were lowered
to reflect the new 10 percent tax bracket that took
the form of a rebate in 2001. All told, the rebate and
other withholding changes are estimated to have reduced personal income tax liabilities by $44 billion in
calendar year 2001 and are expected to lower them
by $52 billion in 2002. The lower taxes enable households to increase spending and pay down debt. Adding
in all the other major personal income tax reductions,
EGTRRA is estimated to reduce taxpayers’ 2002 calendar year liabilities by about $70 billion.
In this Budget, the Administration proposes an economic security package to insure that the economy recovers quickly from the recession. The package includes:
speeding up the income tax reductions Congress passed
last year as part of EGTRRA; tax refunds to lowerand moderate-income families who did not benefit from
the income tax rebates in 2001; providing partial expensing of new investment and reforming the corporate
alternative minimum tax. In addition, the Administration supports measures to provide immediate assistance
to laid-off workers, both by extending their unemployment benefits and helping them retain their health insurance coverage.
Monetary Policy: Beginning in early 2001, the Federal
Reserve consistently pursued an easier monetary policy
to reinvigorate the unexpectedly weak economy and to
offset the shock to confidence from the terrorist attacks
of September 11th. The Federal Reserve cut the Federal
funds rate by one percentage point in January 2001
and by one-half percentage point in March. In the following months, and especially after September 11th,
the Federal Reserve further reduced the Federal funds
rate. All told, the funds rate was cut eleven times during 2001, reducing it from 6-1⁄2 percent to 1-3⁄4 percent
by early December, the lowest it has been since the
early 1960s.
Credit markets responded to the monetary easing.
Short-term interest rates matched the decline in the
funds rate. At the long end of the maturity spectrum,

22
yields had already declined substantially in late 2000
in anticipation of the Fed’s shift in policy, and then
fluctuated somewhat during 2001 as prospects for recovery varied. On October 31st, the Treasury announced it was halting sales of the 30-year bond, and
the yield on long-term Treasury notes dropped sharply,
but within a month yields returned to pre-announcement levels. By January 2002, as the recovery in economic activity appeared close at hand, the yield on
the 10-year Treasury note had risen to 5.1 percent,
close to the level at which it began 2001. The steeply
upward sloping yield curve at the start of 2002 was
another signal from credit markets that the economy
was about to emerge from recession to recovery.
The Recession and the Post-September 11th Economy:
The terrorist attacks pushed a weak economy over the
edge into an outright contraction. After September
11th, the forces that had been restraining growth since
mid-2000 were augmented by temporary disruptions to
business travel and tourism and by the temporary
shock to confidence that the terrorist attacks had engendered. As a result, real GDP decreased at a 1.3
percent annual rate in the July-September quarter and
probably contracted in the October-December quarter
as well. 2 Consumer and business confidence plummeted
immediately after September 11th. The Conference
Board’s survey of consumer confidence dropped 26 percent from August to October. When the financial markets reopened following the attacks, there were sharp
declines in asset values. On September 21st, when the
stock market hit its low point, the S&P 500 was off
12 percent from its close on September 10th; the
NASDAQ was down 16 percent.
Clear signs that the recession was taking hold also
appeared in the Nation’s labor markets. Payrolls began
to shrink after the March business cycle peak but the
largest job losses followed the September 11th attacks.
All in all, 1.1 million jobs were lost last year, with
over 943 thousand jobs lost in the last three months
of the year. Manufacturing industries, and especially
high-tech and other capital goods industries, experienced the largest job losses. But even the job-generating
private service sector industries lost nearly 300,000 jobs
last year. Initial claims for unemployment insurance
surged during the second half of September and well
into October. Layoffs accelerated, especially in industries directly affected by the attacks, such as the airlines, hotels, restaurants and car rentals. The unemployment rate jumped from 5.0 percent in September
to 5.8 percent by December. For the year as a whole,
the unemployment rate averaged 4.8 percent, the highest level since 1997. The weakening labor market last
year was also evident in the declines in the labor force
participation rate and in the employment-population
ratio.
The growing underutilization of physical capital,
which began in late 2000, became more pronounced
in 2001, especially, after September 11th. By December,
2 The first official estimate of fourth quarter GDP was released at the end of January,
after this text was finalized.

ANALYTICAL PERSPECTIVES

the manufacturing capacity utilization rate was only
73 percent, well off the 82 percent of mid-2000. The
operating rate in high-tech industries fell to 60 percent
in December, the lowest level for those industries since
record-keeping began in the 1960s.
Signs of Recovery: In the closing months of 2001,
there were tentative signs that the economy was about
to emerge from the recession. After hitting bottom on
September 21st, the stock market rose sharply and the
yield curve steepened. Consumer confidence jumped 10
percent in December, and surveys revealed that consumers’ expectations about the future had nearly returned to the levels attained in August.
Despite the shocks to confidence, consumers were still
willing to make big-ticket purchases in the fourth quarter. Motor vehicle sales set a record high in the quarter,
spurred by zero-percent financing. In past recessions,
housing activity contracted sharply while consumer
spending usually declined at some point. That pattern
was not repeated this time. The considerable stimulus
provided by the tax reductions and lower interest rates,
and the restoration of confidence following early successes in the war on terrorism, appear to have sustained the household sector through this turbulent period.
Other signs of improvement could be seen in the
labor markets, where the number of new claims for
unemployment insurance tapered off sharply in November and again in December, while job losses in December were much less than in either October or November. Finally, business capital goods orders rose substantially in October and November, a signal that businesses were again beginning to undertake long-term
investment commitments. As 2002 began, most forecasters were projecting that real GDP growth would
resume in the first or second quarter of the year.
Nonetheless, a resumption of strong growth later this
year is far from assured. The recent recovery of business and consumer confidence is still fragile and could
be shattered by any adverse shocks. Job losses in December, although less than a few months earlier, were
substantial and the unemployment rate was still on
the rise. Faced with uncertainties about job security,
consumers may yet cut back on spending as has often
occurred in recessions. Businesses may still be reluctant
to invest heavily in new plant and equipment. Finally,
it may prove difficult for the hard-hit manufacturing
sector to pull out of recession given the continuing
weakness in U.S. export markets.
Economic Projections
The Administration’s economic projections are summarized in Table 2–1. They assume that the policies
proposed in the Budget will be adopted, notably the
bipartisan economic security package to insure that the
recovery does not falter. The Federal Reserve is assumed to pursue a monetary policy that supports a
return to sustainable growth while continuing to keep
inflation under control. These economic assumptions
are conservative and close to those of the Congressional

23

2. ECONOMIC ASSUMPTIONS

Table 2–1.

ECONOMIC ASSUMPTIONS 1

(Calendar years; dollar amounts in billions)
Actual
2000
Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars ................................................................
Real, chained (1996) dollars ..........................................
Chained price index (1996=100), annual average ........
Percent change, fourth quarter over fourth quarter:
Current dollars ................................................................
Real, chained (1996) dollars ..........................................
Chained price index (1996=100) ....................................
Percent change, year over year:
Current dollars ................................................................
Real, chained (1996) dollars ..........................................
Chained price index (1996=100) ....................................

Projections
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

9,873 10,197 10,481 11,073 11,681 12,321 12,962 13,614 14,299 15,020 15,775 16,569 17,404
9,224 9,313 9,382 9,739 10,101 10,462 10,802 11,136 11,482 11,838 12,204 12,583 12,973
107.0 109.5 111.7 113.7 115.6 117.8 120.0 122.2 124.5 126.8 129.2 131.6 134.1
5.3
2.8
2.4

1.9
–0.5
2.4

4.7
2.7
1.9

5.6
3.8
1.7

5.5
3.7
1.7

5.4
3.5
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

6.5
4.1
2.3

3.3
1.0
2.3

2.8
0.7
2.0

5.6
3.8
1.8

5.5
3.7
1.7

5.5
3.6
1.8

5.2
3.2
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

5.0
3.1
1.9

Incomes, billions of current dollars:
Corporate profits before tax ...........................................
Wages and salaries ........................................................
Other taxable income 2 ...................................................

845
4,837
2,236

706
5,100
2,297

733
5,246
2,331

848
5,519
2,458

931
5,818
2,547

1,023
6,115
2,650

1,090
6,415
2,750

1,136
6,730
2,839

1,188
7,058
2,937

1,251
7,401
3,042

1,312
7,763
3,152

1,354
8,147
3,265

1,419
8,549
3,386

Consumer Price Index (all urban): 3
Level (1982–84=100), annual average ..........................
Percent change, fourth quarter over fourth quarter ......
Percent change, year over year ....................................

172.3
3.4
3.4

177.2
2.0
2.9

180.5
2.4
1.8

184.5
2.2
2.2

188.7
2.3
2.3

193.2
2.4
2.4

197.8
2.4
2.4

202.6
2.4
2.4

207.4
2.4
2.4

212.4
2.3
2.4

217.3
2.3
2.3

222.3
2.3
2.3

227.4
2.3
2.3

4.0
4.0

5.5
4.8

5.8
5.9

5.4
5.5

5.1
5.2

4.9
5.0

4.9
4.9

4.9
4.9

4.9
4.9

4.9
4.9

4.9
4.9

4.9
4.9

4.9
4.9

4.8
4.8

3.7
3.7

6.9
4.6

4.1
2.6

3.4
3.4

3.4
3.4

3.4
3.4

3.4
3.4

3.4
3.4

3.4
3.4

3.4
3.4

3.4
3.4

3.4
3.4

5.8
6.0

3.4
5.0

2.2
5.1

3.5
5.1

4.0
5.1

4.3
5.1

4.3
5.2

4.3
5.2

4.3
5.2

4.3
5.2

4.3
5.3

4.3
5.3

4.3
5.3

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 late November 2001.
interest, dividend and proprietor’s components of personal income.
adjusted CPI for all urban consumers.
4 Percentages apply to basic pay only; 2002 figure is average of various rank- and longevity-specific adjustments; 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, secondary market (bank discount basis).
2 Rent,

3 Seasonally

Budget Office and the consensus of private sector forecasters, as described in more detail below.
There are both upside and downside risks to the assumptions. If the favorable productivity performance
since 1995 is maintained in the years ahead real GDP
growth may be stronger than assumed here. On the
other hand, the recession might prove deeper than expected or the recovery weaker, risks that would increase if Congress again fails to pass the bipartisan
economic security package. The Budget assumptions
take a balanced view of these risks and are intended
to avoid either over- or under-estimation of available
budgetary resources.
Real GDP: Assuming passage of the bipartisan economic security package, the recession is projected to
end early in 2002 and the recovery is expected to be
firmly established during the second half of the year.
On a calendar year basis, real GDP is projected to
rise 0.7 percent in 2002, following a 1.0 percent gain
in 2001. Because of the timing of the business cycle,
the transition from recession to recovery can be seen
more clearly in the fourth-quarter to fourth-quarter

growth rates in Table 2–1, which are –0.5 percent during the recession year of 2001 and 2.7 percent during
the recovery year of 2002. Following the usual cyclical
pattern, during the early stages of the economic expansion real growth is projected to exceed the long-run
sustainable rate. During this period, the unemployment
rate is projected to decline until it reaches a sustainable
level of 4.9 percent in 2005. From 2006 through 2012,
real GDP is projected to increase 3.1 percent per year,
and the unemployment rate is projected to remain at
4.9 percent.
The largest contribution to GDP growth in the nearterm is expected to come as massive inventory liquidation gives way to renewed accumulation during 2002
as businesses rebuild their depleted inventories. Beyond
this year, inventories are likely to grow in line with
sales and their contribution to GDP growth is likely
to be quite small. After 2002, real growth is expected
to be primarily supported by a return to strong growth
of business investment, especially in productive hightech capital, and by the moderate growth of consumer
spending. Overall GDP growth, however, is not pro-

24
jected to return to the very rapid rates experienced
in the last half of the 1990s. During those years, a
stock market boom contributed to unsustainable growth
rates of investment and consumer spending. Residential
investment is expected to benefit from relatively low
mortgage rates and growing demand for second homes
for vacation and retirement. However, underlying demographic trends will make for a relatively moderate
growth of homebuilding in the years ahead.
The Federal, State and local government components
of GDP are also expected to grow at a moderate pace.
Faster growth of Federal spending on security requirements is expected to be coupled with more moderate
growth in other spending. State and local government
spending is projected to be restrained by lingering fiscal
pressures that developed during the recession. During
2002, the foreign sector is likely to exert a drag on
real GDP growth. The recovery of world economic
growth is expected to be led by the United States,
which will tend to increase our imports at a time when
our exports will still be hurt by slow growth abroad.
In subsequent years, growth in our major trading partners is projected to pick up again and the net export
sector will no longer be a source of restraint, and may
even make a small contribution to GDP growth.
Potential GDP: The growth of potential GDP is assumed to be 3.1 percent per year through 2012. Potential growth is approximately equal to the sum of the
trend growth rates of the labor force and productivity.
The labor force component is assumed to rise 1.0 percent per year on average.
Potential productivity in the nonfarm business sector
is assumed to grow 2.1 percent per year during
2002–2012, which is higher than the 1973–1995 average of 1.4 percent but lower than the 1995–2001 average of 2.4 percent. The assumed growth of potential
productivity in the nonfarm business sector is close to
the historical averages experienced both over the longterm of 1948–2001 and over the medium-term between
the cyclical peaks in 1990 and 2001. The potential productivity trend is assumed to be somewhat below the
average productivity growth of the last six years for
two reasons:
• First, growth of business investment last year and
in the next few years is likely to be somewhat
less than experienced during the last half of the
1990s. As a result, there is likely to be a somewhat slower growth of capital per worker.
• Second, the fight against terrorism is likely to
slow potential productivity growth as conventionally measured, at least temporarily. Businesses
and governments will have to spend tens of billions of dollars to reduce the risks of terrorist
attacks and to minimize the damage they might
do if they occur. Although this spending will add
to the Nation’s well-being, much of this spending
will not increase measured productivity growth,
and could possibly diminish it. After a transition
period, however, potential productivity growth is

ANALYTICAL PERSPECTIVES

not likely to be significantly affected by the new
security measures.
Inflation and Unemployment: Price inflation slowed
last year, restrained by falling energy prices and growing slack in labor and capital markets. On a year-overyear basis, the Consumer Price Index (CPI) increased
just 2.8 percent in 2001, down from 3.4 percent in 2000.
Excluding the volatile food and energy components, the
‘‘core’’ CPI rose 2.7 percent last year, which was slightly
higher than the 2.4 percent of 2000.
Over the past year, the consensus of private sector
forecasters and the Administration have edged up their
estimate of the unemployment rate that is consistent
with stable inflation, from 4.6 percent to 4.9 percent.
Although there is a wide range of uncertainty surrounding any estimate of the ‘‘NAIRU’’ (the non-accelerating inflation rate of unemployment), the small increase in both the core CPI last year and in average
hourly earnings suggest that the NAIRU may be slightly higher than last year’s 4.8 percent average unemployment rate. Nonetheless, at 4.9 percent, the NAIRU
estimate is still well below the estimates that prevailed
just a few years ago, reflecting the experience of recent
years that demonstrated that the economy could operate at lower levels of unemployment without experiencing accelerating inflation.
The considerable slack in labor and product markets
created by the recession is expected to restrain the
growth of wages and prices this year. The unemployment rate is projected to decline steadily beginning in
2002 but still remain above the 4.9 percent NAIRU
estimate until 2005, implying progressively lower inflation during these years. The CPI is expected to slow
to 2.4 percent by 2006 and then remain at around
that level. The GDP chain-weighted price index, which
increased 2.3 percent in 2001, is projected to slow to
1.9 percent by 2006 and then stay at that level.
Increases in the CPI tend to be slightly larger than
those of the GDP measure of inflation in part because
sharply falling computer prices exert less of an impact
on the CPI than on the GDP measure. In addition,
the CPI uses a fixed market basket for its weights
while overall GDP inflation uses a chain-weight system
that reflects shifts in buying patterns, generally away
from goods and services with increasing relative prices
and towards those with decreasing relative prices.
Interest Rates: The budget’s interest-rate assumptions
are based on information as of late November. They
project a rise in short-term rates through 2005 because
the transition from recession to expansion will increase
short-term credit demand. The yield on the 10-year
Treasury note is projected to remain at around the
5.1 percent level reached when the assumptions were
finalized. This projection assumes that the market price
as of that date incorporated all relevant information,
including the consensus view that the economy was
about to enter an extended period of sustained economic
growth.
Income Shares: The share of total taxable income in
nominal GDP is projected to decline gradually. The

25

2. ECONOMIC ASSUMPTIONS

share of wages and salaries is expected to trend lower
as the share of nonwage benefits in compensation rises
and as the labor compensation share of GDP declines
to its longer-term average. The profits share, which
fell sharply during the recession, is projected to rise
in the initial recovery years, when a cyclical increase
in productivity growth is likely to hold down unit costs
and boost profit margins.
Comparison with CBO and Private-Sector
Forecasts
The Congressional Budget Office (CBO) and many
private-sector forecasters also make projections. The
CBO projection is used by Congress in formulating
budget policy. In the executive branch, this function
is performed jointly by the Treasury, the Council of
Economic Advisers, and the Office of Management and
Budget. Private-sector forecasts are often used by businesses for long-term planning. Table 2–2 compares the
Budget assumptions with projections by the CBO and
the Blue Chip consensus, an average of about 50 private forecasts.
The Administration’s projections assume that the
President’s policy proposals in the Budget, including
Table 2–2.

the economic stimulus package, will be adopted. CBO
normally assumes that current law will continue to
hold. The private sector forecasts are based on appraisals of the most-likely policy outcomes, which can vary
considerably among forecasters. Despite these differences in policy assumptions, the three sets of projections are usually very close for the key economic assumptions. The differences among them are generally
well within the normal margin of error for such forecasts. Currently, the three sets of projections agree on
the timing of the recovery and envision similar economic conditions during the subsequent expansion.
For real GDP growth, the Administration, CBO and
the Blue Chip consensus anticipate that the economy
will recover from the 2001 recession in 2002 and grow
even faster in 2003. The differences between the Administration’s projections in each year and those of the
CBO and Blue Chip are quite small. Over the elevenyear span 2002–2012, all three have an identical forecast average of 3.1 percent annual real GDP growth

COMPARISON OF ECONOMIC ASSUMPTIONS
(Calendar years)
Projections

Real GDP (billions of 1996 dollars):
CBO January ......................................
Blue Chip Consensus January 2 ........
2003 Budget .......................................

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Average,
2002–12

9,398
9,410
9,382

9,782
9,742
9,739

10,146
10,069
10,101

10,471
10,401
10,462

10,804
10,738
10,802

11,145
11,075
11,136

11,493
11,425
11,482

11,850
11,791
11,838

12,216
12,168
12,204

12,590
12,557
12,583

12,972
12,959
12,973

................
................
................

Real GDP (chain-weighted): 1
CBO January ......................................
Blue Chip Consensus January 2 ........
2003 Budget .......................................

0.8
1.0
0.7

4.1
3.4
3.8

3.7
3.4
3.7

3.2
3.3
3.6

3.2
3.2
3.2

3.2
3.1
3.1

3.1
3.2
3.1

3.1
3.2
3.1

3.1
3.2
3.1

3.1
3.2
3.1

3.0
3.2
3.1

3.1
3.1
3.1

Chain-weighted GDP Price Index: 1
CBO January ......................................
Blue Chip Consensus January 2 ........
2003 Budget .......................................

1.4
1.6
2.0

2.0
1.9
1.8

2.0
2.1
1.7

2.0
2.1
1.8

2.0
2.2
1.9

2.0
2.2
1.9

2.0
2.2
1.9

2.0
2.2
1.9

2.0
2.2
1.9

2.0
2.2
1.9

2.0
2.2
1.9

1.9
2.1
1.9

Consumer Price Index (all-urban): 1
CBO January ......................................
Blue Chip Consensus January 2 ........
2003 Budget .......................................

1.8
1.7
1.8

2.5
2.4
2.2

2.5
2.6
2.3

2.5
2.7
2.4

2.5
2.7
2.4

2.5
2.7
2.4

2.5
2.6
2.4

2.5
2.6
2.4

2.5
2.6
2.3

2.5
2.6
2.3

2.5
2.6
2.3

2.4
2.5
2.3

Unemployment rate: 3
CBO January ......................................
Blue Chip Consensus January 2 ........
2003 Budget .......................................

6.1
6.1
5.9

5.9
5.7
5.5

5.4
4.9
5.2

5.2
4.9
5.0

5.2
4.8
4.9

5.2
4.9
4.9

5.2
4.9
4.9

5.2
4.9
4.9

5.2
4.9
4.9

5.2
4.9
4.9

5.2
4.9
4.9

5.4
5.1
5.1

Interest rates: 3
91-day Treasury bills:
CBO January ..................................
Blue Chip Consensus January 2 ....
2003 Budget ...................................

2.2
2.1
2.2

4.5
3.4
3.5

4.9
4.5
4.0

4.9
4.7
4.3

4.9
4.8
4.3

4.9
4.8
4.3

4.9
4.7
4.3

4.9
4.7
4.3

4.9
4.7
4.3

4.9
4.7
4.3

4.9
4.7
4.3

4.6
4.3
4.0

10-year Treasury notes: 3
CBO January ..................................
Blue Chip Consensus January 2 ....
2003 Budget ...................................

5.0
5.1
5.1

5.4
5.6
5.1

5.8
5.7
5.1

5.8
5.7
5.1

5.8
5.7
5.2

5.8
5.8
5.2

5.8
5.8
5.2

5.8
5.8
5.2

5.8
5.8
5.3

5.8
5.8
5.3

5.8
5.8
5.3

5.7
5.7
5.2

Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
1 Year over year percent change.
2 January 2002 Blue Chip Consensus forecast for 2002 and 2003; Blue Chip October 2001 long run extension for 2004–2012.
3 Annual averages, percent.

26

ANALYTICAL PERSPECTIVES

and the level of real GDP projected for 2012 is nearly
the same in the three forecasts. 3
All three forecasts anticipate low and stable GDP
inflation in the neighborhood of 2 percent annually during the forecast period. The Administration’s unemployment rate projection is very close to the Blue Chip’s
while CBO’s projected unemployment rate is somewhat
above the other two forecasts. In the outyears, the Administration and the Blue Chip project a 4.9 percent
rate; CBO projects 5.2 percent. All three forecasts have
similar interest rate projections for 2002, and foresee
a rise in short-term interest rates in 2003 as the expansion gathers momentum. CBO projects a somewhat
sharper rise in 2003 than the other two forecasts. During the outyears, the Blue Chip and CBO short-term
projections are similar and slightly above those of the
Administration. The Administration also projects somewhat less of an increase in long-term rates than the
other two forecasts.
Changes in Economic Assumptions
As shown in Table 2–3, the economic assumptions
underlying this Budget have been revised from those
of the 2002 Budget to reflect unanticipated cyclical developments and the implications of the terrorist attacks. The current projection of real GDP growth has
a pronounced cyclical swing that takes into account
the recession during 2001 and the likely pick-up in
activity in the recovery and expansion phases of the
3 The Blue Chip consensus forecast for 2002–2003 is from January, 2002 Blue Chip Economic Indicators; the 2004–2012 forecast is from October, 2001.

Table 2–3.

business cycle. On a year-over-year basis, real GDP
growth is considerably slower in 2001 and 2002 than
projected in the prior Budget assumptions and faster
during 2003–2006. From 2007 onwards, however, real
GDP growth in this and the prior Budget is projected
to be 3.1 percent yearly, the same as the estimate of
potential GDP growth during those years. Consistent
with the near-term increase in unemployment and the
lower level of interest rates at the end of 2001, inflation
and interest rates are projected to be lower than in
the previous Budget.
Primarily because growth during the initial years of
the expansion is not expected to be as high as the
4 percent or more rate that has occurred in past recoveries, during 2001–2005 real GDP growth is now expected to average 0.5 percentage point less per year
than previously projected. Consequently, as shown in
the table, the level of real GDP is projected to be lower
in each year than forecast in last year’s assumptions,
and from 2006 onward the level of real GDP is now
projected to be about 2 percent lower than envisaged
in last year’s Budget assumptions.
Over the past year, the CBO and the Blue Chip have
made similar reductions in their estimate of average
growth during 2001–2011 and, as a result, have also
lowered their estimate of the level of real GDP in 2011
by an amount similar to that in the Budget assumptions. Thus, the consensus view is that this cycle of
recession and expansion is likely to be different from
those of the past when the level of real GDP eventually
returned to the pre-recession trend. As explained below,

COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2002 AND 2003 BUDGETS
(Calendar years; dollar amounts in billions)

Nominal GDP:
2002 1 .............................................................................................
2003 ...............................................................................................
Real GDP (1996 dollars):
2002 1 .............................................................................................
2003 ...............................................................................................
Real GDP (percent change): 2
2002 ...............................................................................................
2003 ...............................................................................................
GDP price index (percent change): 2
2002 ...............................................................................................
2003 ...............................................................................................
Consumer Price Index (percent change): 2
2002 ...............................................................................................
2003 ...............................................................................................
Civilian unemployment rate (percent): 3
2002 ...............................................................................................
2003 ...............................................................................................
91-day Treasury bill rate (percent): 3
2002 ...............................................................................................
2003 ...............................................................................................
10-year Treasury note rate (percent): 3
2002 ...............................................................................................
2003 ...............................................................................................
1 Adjusted
2 Year

for July 2001 NIPA revisions.
over year.
year average.

3 Calendar

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

10,328
10,197

10,892
10,481

11,478
11,073

12,094
11,681

12,736
12,321

13,413
12,962

14,125
13,614

14,871
14,299

15,657
15,020

16,481
15,775

17,347
16,569

9,440
9,313

9,752
9,382

10,065
9,739

10,387
10,101

10,714
10,462

11,050
10,802

11,397
11,136

11,756
11,482

12,121
11,838

12,494
12,204

12,879
12,583

2.3
1.0

3.3
0.7

3.2
3.8

3.2
3.7

3.1
3.6

3.1
3.2

3.1
3.1

3.1
3.1

3.1
3.1

3.1
3.1

3.1
3.1

2.1
2.3

2.1
2.0

2.1
1.8

2.1
1.7

2.1
1.8

2.1
1.9

2.1
1.9

2.1
1.9

2.1
1.9

2.1
1.9

2.1
1.9

2.7
2.9

2.6
1.8

2.6
2.2

2.5
2.3

2.5
2.4

2.5
2.4

2.5
2.4

2.5
2.4

2.5
2.4

2.5
2.3

2.5
2.3

4.4
4.8

4.6
5.9

4.5
5.5

4.5
5.2

4.5
5.0

4.5
4.9

4.5
4.9

4.6
4.9

4.6
4.9

4.6
4.9

4.6
4.9

5.3
3.4

5.6
2.2

5.6
3.5

5.6
4.0

5.3
4.3

5.0
4.3

5.0
4.3

5.0
4.3

5.0
4.3

5.0
4.3

5.0
4.3

5.4
5.0

5.6
5.1

5.7
5.1

5.7
5.1

5.7
5.1

5.7
5.2

5.7
5.2

5.7
5.2

5.7
5.2

5.7
5.3

5.7
5.3

27

2. ECONOMIC ASSUMPTIONS

the unusual nature of this business cycle implies substantially lower projected budget surpluses, even when
the economy returns to its potential growth rate.
The slower average real GDP growth rate for the
forecast period, and the resulting lower level of real
GDP, primarily reflects three factors:
• First, the overhang of capital that developed unexpectedly during 2001 has resulted in lower actual
business investment during 2001 and slower
growth of investment for the next few years than
projected in the 2002 Budget assumptions. As a
result, productivity growth for the next few years
is projected to be somewhat slower because of the
slower growth of capital per worker.
• Second, in the aftermath of the September 11th
terrorist attacks, resources which might have been
invested in expanding productive capacity will be
diverted to enhance security. This diversion will
slow productivity growth and real GDP growth
slightly for the next few years.
• Finally, the Administration’s estimate of the longrun sustainable level of the unemployment rate
has been revised up modestly from 4.6 percent
to 4.9 percent, as has the Blue Chip’s, which implies a lower level of real GDP for the largely
unchanged projected labor force.
Sources of Change in the Budget Since Last
Year
The sources of the change in the budget outlook from
the 2002 Budget pre-policy baseline to the 2003 Budget
policy projection are shown in Table 2–4. The second
block shows that enacted legislation reduced the projected pre-policy surpluses of $5.6 trillion during
2002–2011 by $2.1 trillion.
The third and fourth blocks quantify the impact on
the budget outlook from changes in the economic assumptions and technical factors. Technical factors are
those changes that are not due to explicit economic
assumptions or legislation, such as income from stock
options and the effective tax rate on corporate profits.
Because of the interaction of economic developments
and technical factors, it is difficult to estimate accurately their separate budgetary impacts. Block 5 shows
that the combined changes due to economic and technical factors reduced projected surpluses by $1,345 billion. The Addendum shows that the lower projected
level of real GDP in each year accounted for $851 billion of the reduced surpluses. Block 6 shows that policies proposed in this Budget are expected to reduce
cumulative surpluses by $1,556 billion. Block 7 shows
the resulting 2003 Budget policy surplus projection.
Structural and Cyclical Balances
When the economy is operating below potential and
the unemployment rate exceeds the long-run sustainable average, as is projected to be the case for the
next few years, receipts are lower than they would be
if resources were more fully employed, and outlays for
unemployment-sensitive programs (such as unemploy-

ment compensation and food stamps) are higher. As
a result, the surplus is smaller, (or the deficit larger)
than would be the case if unemployment were at the
sustainable long-run average. The portion of the surplus (or deficit) that can be traced to this factor is
called the cyclical component. The balance is the portion that would remain if the unemployment rate were
at its long-run value, which is called the structural
surplus (or structural deficit).
Compared to the actual, unadjusted surplus or deficit,
the structural balance gives a clearer picture of the
stance of fiscal policy because this part of the surplus
or deficit will persist even when the economy is operating at the sustainable level of unemployment. For
this reason, changes in the structural balance give a
better picture of the independent impact of budget policy on the economy than does the unadjusted budget
balance, which reflects the combined impact of policy
and cyclical economic conditions on the budget.
From 1997 to 2001, unemployment was lower than
could be expected to persist in the long run. Therefore,
as shown in Table 2–5, in 1997 the structural deficit
exceeded the actual unadjusted deficit and in
1998–2001 the structural surplus was smaller than the
actual unadjusted structural surplus. In 2002, when
the unemployment rate is projected to be above the
sustainable level, the actual deficit is projected to be
$106 billion at a time when the structural deficit is
expected to be $18 billion. Beginning in 2006, the
unadjusted and the structural surplus are about equal
because the unemployment rate is projected to be at
its sustainable level.
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. Deposit insurance net outlays are
projected to be very small in the coming years. Therefore, the adjusted structural surplus and the unadjusted
structural surplus are nearly identical during the forecast horizon.
Sensitivity of the Budget to Economic
Assumptions
Both receipts and outlays are affected by changes
in economic conditions. This sensitivity 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 or deficit.
Economic variables that affect the budget do not usually change independently of one another. Output and

28

ANALYTICAL PERSPECTIVES

Table 2–4.

SOURCES OF CHANGE IN BUDGET TOTALS
(In billions of dollars)
2002

(1) 2002 Budget baseline
Receipts .............................................................................................................................
Outlays ..............................................................................................................................

2003

2004

2005

2006

20022011

2007

2,221
1,938

2,324
1,991

2,438
2,051

2,569
2,130

2,698
2,182

2,836
2,250

283

334

387

439

515

585

5,637

–33
61

–83
62

–104
70

–102
76

–126
86

–137
95

–1,127
943

Surplus reduction (-), enacted legislation ....................................................................
(3) Changes due to economic assumptions:
Receipts .............................................................................................................................
Outlays ..............................................................................................................................

–95

–145

–174

–179

–212

–232

–2,070

–82
–7

–91
–15

–81
–13

–87
–12

–100
–11

–109
–8

–1,077
–63

Surplus reduction (-), economic ...................................................................................
(4) Changes due to technical factors:
Receipts .............................................................................................................................
Outlays ..............................................................................................................................

–76

–76

–67

–75

–89

–101

–1,014

–94
27

–29
32

–19
18

–14
3

–10
8

–9
3

–197
135

Surplus reduction (-), technical ....................................................................................

–121

–61

–37

–17

–19

–12

–331

(5) Surplus reduction, economic and technical subtotal .................................................

–197

–138

–104

–92

–108

–114

–1,345

(6) Changes due to 2003 Budget policy:
Receipts .............................................................................................................................
Outlays ..............................................................................................................................

–65
32

–73
59

–59
63

–28
80

–6
103

–9
126

–414
1,143
–1,556

Unified budget surplus .................................................................................................
(2) Changes due to enacted legislation:
Receipts .............................................................................................................................
Outlays ..............................................................................................................................

Surplus reduction (-), policy .........................................................................................
(7) 2003 Budget totals (policy)
Receipts .............................................................................................................................
Outlays ..............................................................................................................................

–97

–132

–122

–108

–110

–136

1,946
2,052

2,048
2,128

2,175
2,189

2,338
2,277

2,455
2,369

2,572
2,468

Unified budget surplus .................................................................................................

–106

–80

–14

61

86

104

665

Addendum:
Surplus Reduction due to Change in Economic Assumptions:
Lower Real GDP ...............................................................................................................
Higher Unemployment ......................................................................................................
Lower Inflation ...................................................................................................................
All Other ............................................................................................................................

–70
–16
–1
11

–85
–7
–1
16

–79
–4
–2
18

–75
–3
–6
9

–75
–4
–10
–1

–80
–6
–15
–1

–851
–64
–159
60

Surplus reduction (-), economic ...................................................................................

–76

–76

–67

–75

–89

–101

–1,014

Note: Changes in interest costs due to receipts changes included in outlay lines.

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 force, 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 budgetary effects of the above rules
of thumb are shown in Table 2–6.

For real growth and employment:
• As shown in the first block, if real GDP growth
is lower by one percentage point in calendar year
2002 only and the unemployment rate rises by
one-half percentage point more than in the budget
assumptions, the fiscal year 2002 deficit is estimated to increase by $11.5 billion; receipts in 2002
would be lower by $9.3 billion, and outlays would
be higher by $2.1 billion, primarily for unemployment-sensitive programs. In fiscal year 2003, the
estimated receipts shortfall would grow further to
$19.3 billion, and outlays would increase by $7.1
billion relative to the base, even though the
growth rate in calendar 2003 equaled the rate
originally assumed. This is because the level of
real (and nominal) GDP and taxable incomes
would be permanently lower, and unemployment
permanently higher. The budget effects (including

29

2. ECONOMIC ASSUMPTIONS

Table 2–5.

ADJUSTED STRUCTURAL BALANCE
(In billions of dollars)

1996

1997

Unadjusted surplus or deficit (–) ......................................
Cyclical component .......................................................

–107.5
–13.7

–22.0
15.5

Structural surplus or deficit (–) .........................................
Deposit insurance outlays ............................................

–91.5
–8.4

Adjusted structural surplus or deficit (–) ..........................

–99.9

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

69.2
45.3

124.6
64.3

236.4
81.9

127.1
42.1

–106.2
–88.0

–80.2
–77.5

–13.7
–45.5

61.1
–17.5

86.2
–0.5

104.0
0.0

–27.9
–14.4

35.7
–4.4

79.8
–5.3

164.4
–3.1

85.0
–1.4

–18.2
0.2

–2.7
1.4

31.7
0.4

78.7
–0.2

86.7
–0.3

104.0
–0.4

–42.3

31.3

74.5

161.3

83.5

–17.9

–1.3

32.1

78.5

86.4

103.6

NOTE: The NAIRU is assumed to be 5.2% through calendar year 1998 and 4.9% thereafter.

growing interest costs associated with smaller surpluses) would continue to grow slightly in each
successive year. During 2003–2012, the cumulative reduction in the budget surplus is estimated
to be $394 billion.
• The budgetary effects are much larger if the real
growth rate is one percentage point lower in each
year than initially assumed and the unemployment rate is unchanged, as shown in the second
block. This scenario might occur if trend productivity is permanently lower than initially assumed.
In this case, the estimated reduction in the surplus is much larger than in the first scenario.
In this example, during 2003–2012, the cumulative reduction in the budget surplus is estimated
to be $1.9 trillion.
Joint changes in interest rates and inflation have
a smaller effect on the surplus than equal percentage
point changes in real GDP growth.
• The third block shows the effect of a one percentage point higher rate of inflation and one percentage point higher interest rates during calendar
year 2002 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. In 2003,
outlays would be above the base by $16.4 billion,
due in part to lagged cost-of-living adjustments;
receipts would rise $21.4 billion above the base,
however, resulting in an $5.1 billion improvement
in the budget balance. In subsequent years, the
amounts added to receipts would continue to be
larger than the additions to outlays. During
2003–2012, cumulative budget surpluses would be
$106 billion larger than in the base case.
• In the fourth block example, the rate of inflation
and the level of interest rates are higher by one
percentage point in all years. As a result, the price
level and nominal GDP 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 $775 billion
to outlays over 2003–2012 and $1,559 billion to
receipts, for a net increase in the 2003–2012 surpluses of $784 billion. This rule-of-thumb now
shows a more positive net budget outcome than
was estimated a few years ago, when the interest
outlays were larger because of higher levels of
public debt.
The table also 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 in part
because the combined effects of two changes in assumptions affecting debt financing patterns and interest
costs may differ from the sum of the separate effects.
• The outlay effects of a one percentage point increase in interest rates alone is now relatively
small, as shown in the fifth block. The receipts
portion of this rule-of-thumb is due to the Federal
Reserve’s deposit of earnings on its securities portfolio.
• The sixth block shows that a sustained one percentage point increase in the GDP chain-weighted
price index and in CPI inflation increase cumulative surpluses by a substantial $962 billion during 2003–2012. This large effect is because the
receipts from a higher tax base exceeds the combination of higher outlays from mandatory costof-living adjustments and lower receipts from CPI
indexation of tax brackets.
The last entry in the table shows rules of thumb
for the added interest cost associated with changes in
the budget surplus or deficit.
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.

30

ANALYTICAL PERSPECTIVES

Table 2–6.

SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
(In billions of dollars)
2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

20032012

–9.3
2.1

–19.3
7.1

–21.3
7.4

–22.3
9.1

–23.1
11.0

–24.1
13.0

–25.4
14.9

–26.7
16.8

–28.0
19.0

–29.3
21.4

–30.9
24.0

–250.4
143.7

Decrease in surplus (–) .....................................
(2) Sustained during 2002–2012, with no change in
unemployment:
Receipts ..................................................................
Outlays ....................................................................

–11.5

–26.5

–28.7

–31.4

–34.2

–37.1

–40.2

–43.5

–47.1

–50.7

–54.8

–394.1

–9.4
–*

–29.9
0.3

–54.7
1.9

–82.0
4.6

–110.4
8.4

–141.5
13.4

–175.1
19.4

–211.8
26.4

–251.1
35.3

–292.4
45.9

–338.2
58.4

–1,687.1
214.0

Decrease in surplus (–) .....................................

–9.4

–30.2

–56.6

–86.6

–118.8

–154.9

–194.5

–238.2

–286.4

–338.3

–396.6

–1,901.1

10.6
8.4

21.4
16.4

20.9
14.4

19.3
12.2

20.1
11.8

21.1
11.3

22.3
11.0

23.6
11.1

24.9
11.2

26.3
11.4

28.1
11.2

228.0
121.8

2.2

5.1

6.4

7.1

8.3

9.8

11.3

12.5

13.7

15.0

16.9

106.2

10.6
8.3

32.7
24.4

55.4
37.9

77.9
49.9

101.8
61.0

128.5
71.8

158.2
83.0

191.6
94.4

228.3
106.0

268.6
118.3

315.6
128.2

1,558.7
774.8

Increase in surplus (+) ......................................
(5) Interest rates only, sustained during 2002–2012:
Receipts ..................................................................
Outlays ....................................................................

2.3

8.3

17.5

28.0

40.8

56.7

75.3

97.2

122.3

150.4

187.4

783.9

1.4
6.8

3.7
17.0

4.7
22.9

5.2
26.1

5.6
28.1

6.0
29.6

6.4
30.5

6.8
31.2

7.2
31.5

7.6
31.4

8.0
30.8

61.1
279.1

Decrease in surplus (–) .....................................
(6) Inflation only, sustained during 2002–2012:
Receipts ..................................................................
Outlays ....................................................................

–5.4

–13.3

–18.2

–20.9

–22.5

–23.6

–24.1

–24.3

–24.3

–23.9

–22.8

–217.9

9.2
1.5

29.0
7.6

50.7
15.5

72.8
24.8

96.2
34.6

122.5
44.7

151.8
56.0

184.8
68.0

221.1
80.9

261.0
95.2

307.6
108.2

1,497.6
535.6

Increase in surplus (+) ......................................

7.7

21.4

35.2

47.9

61.6

77.8

95.8

116.8

140.2

165.8

199.4

962.0

Interest Cost of Higher Federal Borrowing
(7) Outlay effect of $100 billion increase in the 2002
unified deficit ...............................................................

1.3

3.5

4.4

4.9

5.2

5.5

5.7

5.9

6.2

6.5

6.8

54.8

Budget effect
Real Growth and Employment
Budgetary effects of 1 percent lower real GDP
growth:
(1) For calendar year 2002 only: 1
Receipts ..................................................................
Outlays ....................................................................

2002

Inflation and Interest Rates
Budgetary effects of 1 percentage point higher rate
of:
(3) Inflation and interest rates during calendar year
2002 only:
Receipts ..................................................................
Outlays ....................................................................
Increase in surplus (+) ......................................
(4) Inflation and interest rates, sustained during
2002–2012:
Receipts ..................................................................
Outlays ....................................................................

* $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.

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET
Introduction
The Government’s financial condition can only be
properly evaluated using a broad range of data—more
than would usually be shown on a business balance
sheet—and several complementary perspectives. This
chapter presents a framework for such analysis. No
single table in the chapter is the equivalent of a Federal balance sheet, but taken as a whole, the chapter
provides an overview of the Government’s resources,
the current and future claims on them, and some idea
of 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, modified to take into account the Government’s
unique roles and circumstances.
Because there are important differences between Government and business, and because there are serious
limitations on the available data, this chapter’s findings
should be interpreted with caution; its conclusions are
tentative and subject to future revision.
The presentation consists of three parts:
• Part I reports on what the Federal Government
owns and what it owes. Table 3–1 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. The
table provides a comprehensive estimate of the
value of the assets actually owned by the Government, but the Government is able to draw on resources in addition to these. It can tax and use
other measures to meet future obligations. The
liabilities shown in the table include all the binding commitments resulting from prior Government
action, but the Government’s responsibilities are
much broader than this.
• Part II presents possible paths for the Federal
budget extending beyond the normal budget window and summarized in Table 3–2. This Part
shows the full scope of the Government’s longrun financial burdens and the resources that it
will have available to meet them. Some future
claims on the Government deserve special emphasis because of their importance to individuals’ retirement plans. Table 3–3 summarizes the condition of the Social Security and Medicare trust

funds and how that condition changed between
2000 and 2001.
• Part III features information on national economic
and social conditions which are affected by what
the Government does. Table 3–4 presents summary data for total national wealth, while highlighting the Federal investments that have contributed to that wealth. Table 3–5 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
(FASAB) 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 is an experimental approach
for meeting this objective at the Government-wide 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 or deficit, does not provide all the
information needed to analyze the Government’s financial and investment decisions. While a business is ultimately judged by a single number—the bottom line in
its balance sheet—for the national Government the ultimate test is how its actions affect the country, and
that is not possible to sum up with a single statistic.
1 Statement of Federal Financial Accounting Concepts, Number 1, Objectives of Federal
Financial Reporting, September 2, 1993. Other objectives are budgetary integrity, operating
performance, and systems and controls.

31

32

ANALYTICAL PERSPECTIVES

The data needed to judge the Government’s performance go beyond the assets its owns or the liabilities
that might appear on a balance sheet. 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 State and local governments. From a balance-sheet standpoint, these investments might appear

to be superfluous or even wasteful, since the Government does not own the assets that these investments
generate; but such investments can make a real contribution to the economy and to people’s lives. A framework for evaluating Federal finances needs to take into
account the value of such Federal investments, even
when the return they earn does not accrue to the Federal Government.

QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’
1. According to Table 3–1, 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?
The Federal Government has fundamentally different objectives from a business enterprise. The
primary goal of every business is to earn a profit, and the Federal Government properly leaves
almost all activities at which a profit could be earned to the private sector. For the vast bulk of
the Federal Government’s operations, it would be difficult or impossible to charge prices—let
alone prices that would cover expenses. The Government undertakes these activities not to improve its balance sheet, but to benefit the Nation—to foster not only monetary but also nonmonetary values.
For example, 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 if they
are successful. The returns on these investments show up not as an increase in the Government
assets but as an increase in the general state of knowledge and in the capacity of the country’s
citizens to earn a living. A business’s motives for investment are quite different; business invests
to earn a profit for itself, not others, and if its investments are successful, their value will be reflected in its balance sheet. Because the Federal Government’s objectives are different, its balance sheet behaves differently, and should be interpreted differently.
2. Table 3–1 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. These powers, which include taxation, allow the Government to meet its present obligations and those that are anticipated from future operations even though the Government’s assets are less than its liabilities.

3.

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. 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.
Why does the Government not keep a proper set of books?
The Government is not a business, and accounting standards designed to illuminate how much a
business earns and how much equity it has could provide misleading information if applied to
the Government. The Federal Accounting Standards Advisory Board (FASAB) has developed,
and the Government has adopted, a conceptual accounting framework that reflects the Government’s distinct functions and answers the questions for which Government should be accountable. This framework addresses budgetary integrity, operating performance, stewardship, and
systems and controls. FASAB has also developed, and the Government has adopted, a full set

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’—Continued
of accounting standards. Federal agencies now issue audited financial reports that follow these
standards and an audited Government-wide consolidated financial report is now being issued as
well. The American Institute of Certified Public Accountants (AICPA) has recognized FASAB as
the body designated to establish generally accepted accounting principles (GAAP) for Federal
governmental entities. In short, the Federal Government does follow GAAP just as businesses
and State and local governments do for their activities, although the relevant principles differ
among the groups.
This chapter is intended to address the ‘‘stewardship objective’’—assessing the interrelated condition of the Federal Government and the Nation. The data in this chapter illuminate the tradeoffs and connections between making the Federal Government ‘‘better off’’ and making the Nation ‘‘better off.’’ The Government does not have a ‘‘bottom line’’ comparable to that of a business
corporation, and some analysts have found the absence of a bottom line to be frustrating, but it
would not help to pretend that such a number exists when clearly it does not.
4. Why is Social Security not shown as a liability in Table 3–1?
Future Social Security benefits are a political and moral responsibility of the Federal Government, but these benefits are not a liability in the usual sense. The Government has unilaterally
decreased as well as increased Social Security benefits in the past, and future reforms could
alter them again. When the amount in question can be changed unilaterally, it is not ordinarily
considered a liability.
Other Federal programs exist that are similar to Social Security in the promises they make—
Medicare, Medicaid, Veterans pensions, and Food Stamps—for example. Few have suggested
counting the future benefits expected under these programs as Federal liabilities, yet it would
be difficult to justify a different accounting treatment for them if Social Security were to be classified as a liability. There is no bright line dividing Social Security from other programs that
promise benefits to people, and all the Government programs that do should be accounted for
similarly.
Furthermore, if future Social Security benefits were to be treated as a liability, logic would suggest that future payroll tax receipts that are earmarked to finance those benefits ought to be
considered an asset. Other tax receipts, however, are not counted as Government assets, and for
good reason. The Government does not own the wealth on which its future taxes depends.
Counting other taxes on the Government’s balance sheet would be wrong, while treating Social
Security taxes differently from other taxes would be highly questionable.
Under Generally Accepted Accounting Principles (GAAP), Social Security is not considered to be
a liability, so omitting it from Table 3–1 is consistent with the accounting standards developed
by FASAB.
5. When the baby-boom generation begins to retire in large numbers about ten years from
now, the deficit could be larger than it ever was before. Should this not be reflected in evaluating the Government’s financial condition?
The aging of the U.S. population will become dramatically evident when the baby-boomers begin
to retire, and this demographic transition poses serious long-term problems for Federal entitlement programs and the budget. The second part of this chapter describes how the budget is likely to evolve under possible alternative scenarios when the baby-boomers retire and beyond. It is
clear from these projections, and from similar information provided by the annual Trustees’ Reports for Social Security and Medicare, that reforms are needed in these programs to meet the
long-term challenges.

33

34

ANALYTICAL PERSPECTIVES

QUESTIONS AND ANSWERS ABOUT THE GOVERNMENT’S ‘‘BALANCE SHEET’’—Continued
6. Would it be sensible for the Government to borrow to finance needed capital—permitting
a deficit in the budget—so long as the borrowing did not exceed the amount spent on investments?
This rule might not actually permit much extra borrowing. If the Government were to finance
new capital by borrowing, it should plan to pay off the debt incurred to finance old capital as the
capital is used up. The net new borrowing permitted by this rule should not exceed the amount
of net investment after adjusting for capital consumption, but as discussed in Chapter 7 of Analytical Perspectives, Federal net investment in physical capital is usually not very large and on
occasion has even been negative, so little deficit spending would have been justified by this borrowing-for-investment criterion, at least in recent years.
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. It is not clear whether this type of capital investment would fall under the borrowing-for-investment criterion. Certainly, these investments
do not create Federally owned assets, which suggests they should not be included for this purpose even though they are an important part of national wealth.
There is another difficulty with the logic of borrowing to invest. Businesses expect investments
to earn a return large enough to cover their cost. In contrast, the Federal Government does not
generally expect to receive a direct payoff 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 of time is no justification for excluding
them when calculating the surplus or deficit.
Finally, the Federal Government must pursue policies that support the overall economic wellbeing of the Nation and its security interests. For such reasons, the Government may deem it
desirable to run a budget surplus, even if this means paying for its own investments from current receipts, and there will be other times when it is necessary to run a deficit, even one that
exceeds Government net investment. Considerations in addition to the size of Federal investment must be weighed in choosing the right level of the surplus or deficit.
7. Is it appropriate to include the Social Security surplus when measuring the Government’s
consolidated budget surplus?
The Federal budget has many purposes. It should not be surprising that, with more than one
purpose, the budget is presented in more than one way. 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 effects on the economy, it would be misleading
to omit Social Security or any other part of the budget, as all parts of the budget affect the economy.
For purposes of fiscal discipline, leaving out particular Government activities could actually be
dangerous. The principle of a ‘‘unified’’ all-inclusive budget has been used to forestall the practice of moving favored programs off-budget—which has been done to shield those programs from
scrutiny and funding discipline.
For setting long-run fiscal policy, however, an alternative to the unified budget has been useful.
In particular, the Congress has moved Social Security off-budget. The purpose of doing so was to
stress the need to provide independent, sustainable funding for Social Security in the long term;
and to show the extent to which the rest of the budget has relied on annual Social Security surpluses to make up for its own shortfall.

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

Although it should not be the ending point, a good
starting point for analysis is Table 3–1, which shows
the Government’s assets and liabilities. This tabulation
of net liabilities is 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 3–1 clearly
shows that this has not been correct for decades. Government debts are larger than Government assets, although in recent years, Government budget surpluses
did allow the Government to reduce its debt and thereby lower its net liabilities.
On the liabilities side, Table 3–1 includes only the
Government’s binding obligations—such as Treasury
debt and the present discounted value of the pensions
owed to Federal employees, a form of deferred compensation. 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 here
with the other Government liabilities. Although large
in value, these obligations form only a subset of the
Government’s total financial responsibilities.
The Federal Government also has resources that go
beyond the assets that would normally appear on a
balance sheet, such as those that appear in Table 3–1.
These other resources include the Government’s sovereign powers to tax, regulate commerce, and set monetary policy. The best way to analyze the limits of all
of the Government’s fiscal powers is to make a longrun projection of the Federal budget (as is done in
Part II of this chapter). The budget provides a comprehensive measure of the Government’s annual cash
flows. Projecting it forward shows how the Government
is expected to use its powers to generate cash flows
in the future.
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

35
at any time, subject to the decisions of Congress, and
such changes are a regular part of the legislative cycle.
For this and other reasons, these programs are not
Government ‘‘liabilities.’’ It is likely, however, that
many of these programs will remain Federal responsibilities in some form for the foreseeable future, and
they are projected to continue as such in the longrun projections presented in Part II.
The numbers in the budget and in Table 3–1 are
silent on the issue of whether the public is receiving
value for its tax dollars or whether Federal assets are
being used effectively. Information on that point requires performance measures for Government programs
supplemented by appropriate information about conditions in the economy and society. Some such data are
currently available, but more measures need to be developed to obtain a full picture. The changes in budgeting practices discussed in Chapter 1 will contribute
to the long-run goal of more complete information about
Government programs by permitting a closer alignment
of the cost of programs with performance measures.
The presentation that follows consists of a series of
tables and charts. Taken together, they serve a similar
function to a business balance sheet. The schematic
diagram, Chart 3–1, shows how they fit together. The
tables and charts should be viewed as an ensemble,
the main elements of which are grouped in two broad
categories—assets/resources and liabilities/responsibilities.
• Reading down the left-hand side of Chart 3–1
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.

36

ANALYTICAL PERSPECTIVES

Chart 3-1. A Balance Sheet Presentation For The Federal Government
Assets/Resources

Liabilities/Responsibilities

Federal Assets

Federal Liabilities

Financial Assets

Financial Liabilities

Monetary Assets
Mortgages and Other Loans
Other Financial Assets
Less Expected Loan Losses
Physical Assets

Federal Governmental
Assets and Liabilities
(Table 3-1)

Fixed Reproducible Capital
Defense
Nondefense
Non-reproducible Capital
Land
Mineral Rights

Projected Receipts

Net Balance

Long-Run Federal
Budget Projections
(Table 3-2)
Change in Trust
Funds Balances
(Table 3-3)

National Assets/Resources
Federally Owned Physical Assets
State & Local Physical Assets
Federal Contribution

Deposit Insurance
Pension Benefit Guarantees
Loan Guarantees
Other Insurance
Federal Retiree Pension and
Health Insurance Liabilities

Inventories

Resources/Receipts

Debt Held by the Public
Miscellaneous
Guarantees and Insurance

Responsibilities/Outlays
Discretionary Outlays
Mandatory Outlays
Social Security
Health Programs
Other Programs
Net Interest
Surplus/Deficit

National Needs/Conditions
National Wealth
(Table 3-4)

Indicators of economic, social,
educational, and environmental
conditions

Privately Owned Physical Assets
Education Capital
Federal Contribution

Social Indicators
(Table 3-5)

R&D Capital
Federal Contribution

PART I—THE FEDERAL GOVERNMENT’S ASSETS AND LIABILITIES
Table 3–1 summarizes what the Government owes
as a result of its past operations netted against the
value of what it owns for a number of years beginning
in 1960. Assets and liabilities are measured in terms
of constant FY 2001 dollars. Ever since 1960, Government liabilities have exceeded the value of assets (see
chart 3–2). 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 subsequently
those prices declined, and only recently have they regained the level they had reached temporarily in 1980.2
Currently, the total real value of Federal assets is
estimated to be about 35 percent greater than it was
2 This temporary improvement highlights the importance of the other tables in this presentation. What is good for the Federal Government as an asset holder is not necessarily
favorable to the economy. The decline in inflation in the early 1980s reversed the speculative
run-up 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 1960. Meanwhile, Federal liabilities have increased
by 173 percent in real terms. The decline in the Federal
net asset position has been principally due to persistent
Federal budget deficits and the relatively slow increase
in Federal asset holdings, although other factors have
been important in some years. For example, the decline
from 2000 to 2001 was mainly due to a large increase
in promised Federal health benefits for military retirees. The increase in the discounted present value of
these benefits was large enough to offset a unified
budget surplus and a rise in Federal asset values. The
shift from budget deficits to budget surpluses in the
late 1990s reduced Federal net liabilities, which peaked
in 1996. Currently, the net excess of liabilities over
assets is about $3.4 trillion, or $12,000 per capita, compared with net liabilities of $3.9 trillion (FY 2001 dollars) and $14,800 per capita (FY 2001 dollars) in 1995.

37

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

Table 3–1.

GOVERNMENT ASSETS AND LIABILITIES *

(As of the end of the fiscal year, in billions of 2001 dollars)
1960

1965

1970

1975

1980

1985

1990

1995

1999

2000

2001

ASSETS
Financial Assets:
Cash and Checking Deposits ..............................................
Other Monetary Assets .........................................................
Mortgages .............................................................................
Other Loans ..........................................................................
less Expected Loan Losses .............................................
Other Treasury Financial Assets .........................................

43
1
28
102
–1
62

62
1
27
141
–3
77

39
1
40
176
–5
68

31
1
42
176
–9
61

48
2
77
226
–17
86

31
2
78
296
–17
127

42
2
100
209
–20
201

43
1
68
163
–25
241

66
5
81
192
–52
221

57
6
78
191
–38
219

51
12
75
193
–38
232

Total ..................................................................................

235

305

319

302

421

517

535

492

512

513

524

Nonfinancial Assets:
Fixed Reproducible Capital: .................................................
Defense ............................................................................
Nondefense ......................................................................
Inventories .............................................................................
Nonreproducible Capital: ......................................................
Land ..................................................................................
Mineral Rights ..................................................................

1,019
885
134
269
434
94
340

1,020
842
179
233
446
131
315

1,067
851
215
217
428
165
263

974
712
261
194
633
261
372

865
608
257
240
1,014
333
681

1,025
733
292
274
1,088
346
742

1,085
776
309
242
857
355
501

1,125
793
332
171
638
265
373

1,008
671
338
142
737
358
379

979
641
338
142
943
401
542

969
621
348
142
1,013
426
587

Subtotal .......................................................................

1,722

1,699

1,711

1,801

2,119

2,387

2,184

1,934

1,887

2,064

2,124

Total Assets ................................................................

1,957

2,004

2,030

2,103

2,540

2,904

2,718

2,427

2,399

2,577

2,648

1,150
34

1,187
37

1,075
45

1,094
59

1,352
84

2,230
110

3,043
160

4,026
132

3,807
106

3,490
104

3,320
91

1,184

1,224

1,120

1,153

1,437

2,340

3,203

4,158

3,913

3,594

3,412

0
0
0
32

0
0
0
29

0
0
2
22

0
44
7
20

2
32
13
28

9
45
11
17

73
44
16
20

5
21
30
18

1
42
36
17

1
41
38
16

3
51
39
16

32

29

25

71

75

82

154

74

97

97

109

810
194

1,018
244

969
232

1,055
253

1,856
445

1,839
441

1,792
430

1,730
415

1,730
385

1,754
394

1,765
786

1,004

1,262

1,201

1,307

2,301

2,280

2,222

2,144

2,115

2,147

2,551

Total Liabilities ........................................................................

2,220

2,516

2,346

2,531

3,813

4,702

5,579

6,376

6,125

5,837

6,071

Balance .....................................................................................

–263

–511

–316

–428

–1,273

–1,797

–2,861

–3,949

–3,726

–3,261

–3,423

Balance Per Capita (in 2001 dollars) ...................................

–1,461

–2,635

–1,544

–1,983

–5,581

–7,527

–11,431

–14,802

–13,326

–11,527

–11,952

Ratio to GDP (in percent) ......................................................

–10.1

–15.6

–8.1

–9.6

–23.9

–28.4

–38.8

–47.6

–38.2

–32.1

–33.5

LIABILITIES
Financial Liabilities:
Debt held by the Public .......................................................
Trade Payables and Miscellaneous .....................................
Subtotal ...........................................................................
Insurance Liabilities:
Deposit Insurance .................................................................
Pension Benefit Guarantee 1 ................................................
Loan Guarantees ..................................................................
Other Insurance ....................................................................
Subtotal ...........................................................................
Federal Pension and Retiree Health Liabilities
Pension Liabilities .................................................................
Retiree Health Insurance Benefits .......................................
Total ................................................................................

Addenda:.

* This table shows assets and liabilites for the Government as a whole excluding the Federal Reserve System.
1 The model and data used to calculate this liability were revised for 1996–1999.

Assets
Table 3–1 offers a comprehensive list of the financial
and physical resources owned by the Federal Government.
Financial Assets: According to the Federal Reserve
Board’s Flow-of-Funds accounts, the Federal Government’s holdings of financial assets amounted to $0.5
trillion at the end of FY 2001. Government-held mortgages and other loans (measured in constant dollars)
reached a peak in the late 1980s. Since then, the real
value of Federal loans has declined. Holdings of mortgages rose sharply in the late 1980s and then declined
in the 1990s, as the Government acquired mortgages
from failed savings and loan institutions and then liquidated them.

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 about $38 billion as of 2001.
These estimated losses are subtracted from the face
value of outstanding loans to obtain a better estimate
of their economic worth.
Reproducible Capital: The Federal Government is a
major investor in physical capital and computer software. Government-owned stocks of such capital have
amounted to about $1.0 trillion for most of the last
40 years (OMB estimate). This capital consists of defense equipment and structures, including weapons systems, as well as nondefense capital goods. Currently,
slightly less than two-thirds of the capital is defense
equipment or structures. In 1960, defense capital was

38
about 90 percent of the total. In the 1970s, there was
a substantial decline in the real value of U.S. defense
capital and there was another large decline in the
1990s after the end of the Cold War. Meanwhile, nondefense Federal capital has increased at an average
annual rate of around 2–1/2 percent.
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
these resources would never be sold). Researchers in
the private sector have estimated what they are worth,
however, and these estimates are extrapolated in Table
3–1. Private land values fell sharply in the early 1990s,
but they have risen since 1993. It is assumed here
that Federal land shared in the decline and the subsequent recovery. Oil prices have been on a roller coaster
since the mid-1990s. First, they declined sharply in
1997–1998 in the wake of the Asian financial crisis,
which reduced world petroleum demand. In 1999–2000,
oil prices rebounded sharply, but in 2001 they fell
again, although the average for the year remained higher than in FY 2000. The fluctuations caused the estimated value of Federal mineral deposits to fluctuate
as well. (The estimates omit some valuable assets
owned by the Government, such as works of art and
historical artefacts, because the valuation for these assets would have little realistic basis, and because, as
part of the Nation’s historical heritage, these objects
would never be sold.)
Total Assets: The total real value of Government assets is lower now than it was from 1981 through 1992,
mainly because of declines in defense capital and inventories in the 1990s following the end of the Cold War.
Government asset values have risen strongly since
1998, however, propelled by rising prices for land and
energy, and because the decline in defense capital has
moderated. Even with the decline in their estimated
value since 1992, the Government’s asset holdings are
vast. At the end of FY 2001, Government assets are
estimated to be worth about $2.6 trillion.
Liabilities
Table 3–1 covers all those liabilities that would also
appear on a business balance sheet, but only those liabilities. These include various forms of publicly held
Federal debt, Federal pension and health insurance obligations to civilian and military retirees, and the estimated liability arising from Federal insurance and loan
guarantee programs.
Financial Liabilities: Financial liabilities amounted
to about $3.4 trillion at the end of 2001, down from
a peak value of $4.2 trillion in 1996. The single largest
component of these liabilities was Federal debt held
by the public, which amounted to around $3.3 trillion
at the end of FY 2001. In addition to the debt held
by the public, the Government owes about $0.1 trillion
in miscellaneous liabilities. The publicly held debt has
been declining for several years, because of the unified
budget surplus. As the budget returns to deficit, this
decline in public debt will end, but if the deficits remain

ANALYTICAL PERSPECTIVES

small, the ratio of debt and net financial liabilities to
GDP could continue to shrink.
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 large. The figures reported in
Table 3–1 are estimates of the current discounted value
of prospective future losses on outstanding guarantees
and insurance contracts. The 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 about a third since 1990.
Federal Pension and Retiree Health Liabilities: The
Federal Government owes pension benefits as a form
of deferred compensation to retired workers and to current employees who will eventually retire. It also provides its retirees with subsidized health insurance
through the Federal Employees Health Benefits program. The amount of these liabilities is large, and there
was a large increase in these liabilities in 2001. The
discounted present value of the benefits is estimated
to have been around $2.6 trillion at the end of FY
2001 up from $2.1 trillion in 2000.3 The main reason
for the increase was a large expansion in Federal military retiree health benefits legislated in 2001.
The Balance of Net Liabilities
The Government need not maintain a positive balance of net assets to assure its fiscal solvency, and
the buildup in net liabilities since 1960 did not significantly damage Federal creditworthiness. There are,
however, limits to how much debt the Government can
assume without putting its finances in jeopardy. By
1995, Federal net liabilities had reached 48 percent
of GDP, and although this remained well below the
limit that would have threatened Federal creditworthiness, the sharp upward trend in the ratio of liabilities
to GDP, which by 1995 had continued for two decades,
was ominous.
Since then, however, there has been a major reduction in the ratio of Federal net liabilities to GDP. From
1995 through 2000, the net balance as a percentage
of GDP fell for five straight years, and it would have
fallen again in 2001 had there not been a substantial
rise in estimated health insurance liabilities for Federal
retirees last year. This was a one-time increase and
is not expected to be repeated in future years. The
ratio of net liabilities to GDP is down by 30 percent
from its peak level, and the real value—adjusted for
inflation—of net liabilities is $0.6 trillion (FY 2001 dol3 The pension liability is the actuarial present value of benefits accrued-to-date based
on past and projected salaries. The 2001 liability is extrapolated from recent trends. The
retiree health insurance liability is based on actuarial calculation of the present vale of
benefits promised under existing programs. Actuarial estimates are only available since
1997. For earlier years the liability was assumed to grow in line with the pension liability,
and for that reason may differ significantly from what the actuaries would have calculated
for this period.

39

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

lars) lower than at its peak in FY 1996. The decline
in net liabilities reflects the shift from budget deficits
to surpluses, and a recent recovery in some Federal
asset prices. As the budget returns to deficit, net liabil-

ities are likely to increase again for a time, but if the
deficits are relatively small and temporary, most of the
improvement since 1996 ought to be maintained.

Chart 3-2. Net Federal Liabilities
Percent of GDP

50

40

30

20

10

0
1960

1965

1970

1975

1980

1985

1990

1995

2000

PART II—THE BALANCE OF RESOURCES AND RESPONSIBILITIES
This part of the presentation describes long-run projections of the Federal budget that extend beyond the
normal budget horizon. Forecasting the economy and
the budget so far into the future is highly uncertain.
Indeed, accurate forecasting is not really possible over
such a long time period. 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 to name a few. The uncertainties increase the further into the future the projections extend.
Given these uncertainties, the best that can be done
is to work out the implications of expected developments on a ‘‘what if’’ basis by making explicit assumptions and using the analysis to work out their implications. Despite these limitations, long-run budget projections constructed under such assumptions can be useful
in sounding warnings about potential problems. Federal
responsibilities extend well beyond the next five or ten

years, and problems that may be small in that time
frame can become much larger if allowed time to grow.
There is no time limit on the Government’s constitutional responsibilities, and programs like Social Security are intended to continue indefinitely.
The Threat to the Budget from the Impending
Demographic Transition: It is evident even now that
there will be mounting challenges to the budget that
could begin to emerge before the end of this decade.
In 2008, the first of the huge baby-boom generation
born after World War II will reach age 62 and become
eligible for early retirement under Social Security. In
the years that follow, the population over age 62 will
skyrocket, putting serious strains on the budget because of increased expenditures for Social Security and
for the Government’s health programs which serve the
elderly—Medicare and increasingly Medicaid. Longrange projections can help define how serious these
strains might become.
The U.S. population has been aging for decades, but
a major demographic shift is now just over the horizon.

40

ANALYTICAL PERSPECTIVES

The baby-boom cohort has moved into its prime earning
years, while the much smaller cohort born during the
Great Depression has been retiring. Together these
shifts in the population have temporarily held down
the rate of growth in the number of retirees relative
to the labor force. The suppressed budgetary pressures
are likely to burst forth once the baby-boomers begin
to receive Social Security, and that will begin to happen
starting in 2008.
The pressures are expected to persist, however, even
after the baby-boomers are gone. The Social Security
actuaries project that the ratio of workers to Social
Security beneficiaries will fall from around 3–1/2 currently to around 2 by the time most of the babyboomers are retired. Because of lower fertility and improved mortality that ratio is not expected to rise again,
even though it is projected to decline very little following the passing of the baby-boomers. With fewer
workers to pay taxes that support the retired population, the budgetary pressures on the Federal retirement programs will persist. The problem posed by the
demographic transition is a permanent one.

One way to see the extent of the budgetary problem
is to examine the projected spending on Social Security,
Medicare, and Medicaid. Currently, these programs account for 47 percent of non-interest Federal spending;
up from 30 percent in 1980. By 2040, when most of
the remaining baby-boomers will be in their 80s, these
three programs could easily account for two thirds of
non-interest Federal spending. At the end of the projection period, the figure rises to almost three-quarters
of non-interest spending. In other words, under an extension of current budget policy, almost all of the budget would go to these three programs alone. That would
considerably reduce the flexibility of the budget, and
the Government’s ability to respond to new challenges.
Measured relative to the size of the economy, the
three major entitlement programs now amount to 8
percent of GDP.4 By 2040, this share almost doubles
to 14 percent, and in 2075 it is projected to reach 18
percent of GDP. Current projections suggest, absent
structural changes in the programs, that the Federal
Government will have to find another 10 percent of
GDP to cover future benefits in these programs.

Chart 3-3. Entitlements' Claim on the Economy
Percent of GDP

20

18.3
Medicaid

13.9

15

Medicaid
Medicare

10

7.6

Medicare

Medicaid

5

Medicare
Social Security

Social Security

2040

2075

Social Security

0

2001

The Shortfall in Social Security: Social Security
is intended to be self-financing. Workers and employers

pay taxes earmarked for the Social Security trust funds,
and the Funds disburse benefits. In recent years, the

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 2001 dollar by about half by 2030, and by two thirds by 2050. For long-run

comparison, it is much more useful to examine the ratio of budget totals to the expected
size of the economy as measured by GDP.

41

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

Funds have been increasing in size as a result of a
large Social Security surplus. At the end of FY 2001,
the combined Old Age, Survivors and Disability Insurance (OASDI) trust funds had reached almost $1.2 trillion. Under current law, the demographic transition is
projected to reverse this buildup of the trust funds.
The program’s actuaries project that by 2016, taxes
flowing into the Funds will fall short of program benefits and expenses.5 The Funds are projected to continue
to grow for some years beyond this point because of
positive interest income, but by 2025, the trust funds

will peak and begin to be drawn down. By 2038, when
even the youngest baby-boomers will be in their late
70s, the actuaries project that the OASDI trust funds
will be exhausted. That would not mean that Social
Security benefits would cease, because projected taxes
would still be large enough to cover over 70 percent
of projected benefits at that point, but the program
could no longer sustain promised benefits out of earmarked tax receipts and trust fund interest alone (see
accompanying box for a fuller discussion).

Social Security: The Long-Range Challenge
For 66 years, Social Security has provided retirement security and disability insurance for tens of millions of
Americans through a self-financing system. The principle of self-financing is important because it compels corrections to the system in the event of projected financial imbalances.
While Social Security is running surpluses today, OMB projects it will begin running cash deficits within 20 years.
Social Security’s spending path is unsustainable if the demographic trends toward lower fertility rates and longer
life spans continue. These trends imply that the number of workers available to support each retiree will decline
from 3.4 today to an estimated 2.1 in 2030, and that the Government will not be able to meet current-law benefit
obligations at current payroll tax rates
The future size of Social Security’s shortfall cannot be known with any precision. Under the Social Security Trustees’ 2001 intermediate-cost economic and demographic assumptions, the gap between Social Security receipts and
outlays in 2040 is projected to be 1.7 percent of GDP. Under their high-cost assumptions, the shortfall in that year
would be 76 percent larger, or 3.0 percent of GDP. The program’s actuarial deficit, which indicates how much the
payroll tax rate or benefits as a share of payroll would have to change today to maintain a positive balance in the
Trust Funds over the next 75 years, was estimated to be –1.9 percent in the latest Trustees’ report.
Long-range uncertainty underscores the importance of creating a system that is financially stable and self-contained. Otherwise, if the pessimistic assumptions turn out to be more accurate, the demands created by Social Security could compromise the rest of the budget and the Nation’s economic health.
Moreover, the current structure of Social Security leads to substantial generational inequities in the average rate
of return people can expect from the program. While previous generations fared well, individuals born today on
average can expect to receive less than a two percent average annual real rate of return on their payroll tax contributions. Indeed, such estimates overstate the expected rate of return, because they assume no changes in current-law taxes or benefits even though meeting the projected financing shortfall through benefit cuts or additional
revenues would further reduce Social Security’s implicit rate of return for future cohorts. A 1995 analysis found
that the average worker in the cohort born in 2000 would experience a 1.7 percent rate of return before accounting for Social Security’s shortfall, and a 1.5 percent rate of return after adjusting revenues to keep the system solvent.
One way to address the issues of uncertainty and declining rates of return, while protecting national savings,
would be to allow individuals to invest some of the payroll taxes they currently pay in personal retirement accounts. The President’s Commission to Strengthen Social Security has recently reported on various options that
would incorporate personal accounts as part of the Social Security framework. The budget discusses in more detail
the Commission’s findings and the options it has presented for discussion.

5 The long-ranged projections discussed in this chapter are based on an extension of
the Administration’s economic projections from the budget, which differ somewhat from
the economic assumptions used by the actuaries. Under the extended Administration projec-

tions this point would be reached a few years later and the other key dates highlighted
in the Trustee’s annual reports would also come somewhat later.

42

ANALYTICAL PERSPECTIVES

Medicare: The Long-Range Challenge
According to the Medicare Trustees most recent report issued last March, Medicare spending for the Hospital Insurance (HI) program is projected to exceed taxes going into the HI trust fund beginning in 2016, and the fund is
projected to go bankrupt in 2029. Another way of measuring the expected HI shortfall is by the size of the HI
trust fund’s actuarial deficit, defined as the tax rate increase that would be required today to preserve a positive
balance in the HI trust fund over the next 75 years. In their March 2001 report, the Trustees projected an actuarial deficit of –2.0 percent, a two thirds increase over the 2000 estimate of the deficit ,which was –1.2 percent
(see Table 3–3). The large adjustment in the actuarial deficit was mainly due to the Trustees’ acknowledgment
that the growth rate of per capita HI expenditures is likely to be faster in the long run than had previously been
assumed. The new assumption is that per capita HI spending will outpace the rate of growth in per capita GDP
by a full percentage point. Although that marks a substantial increase in the projected growth rate compared with
previous Trustees’ reports, the difference would still be less than it has averaged over the last 20 years.
But, Medicare also has a second trust fund for Supplemental Medical Insurance (SMI), and the growth in per beneficiary SMI expenditures is also projected to exceed the growth rate of per capita GDP by a full percentage point
in the latest Trustees’ report. A comprehensive analysis of Medicare that takes account of both HI and SMI would
show that Medicare already runs a deficit with the rest of the budget, not a surplus. Premiums paid by SMI beneficiaries fall short of total SMI spending, and the difference exceeds the current HI surplus. In fact, over the ten
years 2003–2012, Medicare will require transfers from general revenue totaling $1.3 trillion.
The main reason for the projected shortfall in the Medicare Trust Funds is that the long-range projections of total
Medicare spending show substantial growth. This is partly for demographic reasons. Beginning within ten years,
the number of Medicare beneficiaries is expected to rise very rapidly, as the baby-boomers reach age 65 and become eligible for Medicare. Between 2010 and 2030, the number of persons age 65 and older is expected to rise
from under 40 million to nearly 70 million. Meanwhile, as explained above, per capita spending is also expected to
continue rising rapidly. Together these factors push up total spending very sharply, as a percentage of GDP, Medicare outlays are projected to quadruple increasing from around 2 percent in 2001 to over 8 percent by 2075. This
is the fastest projected growth of any of the major entitlements, faster than both Social Security and Medicaid.
The Administration remains committed to working with Congress to reform Medicare in a manner that improves
the long-run solvency of the entire program without raising Medicare payroll taxes.

And in Medicare: Medicare faces a similar problem.
Income to Medicare’s Hospital Insurance (HI) trust
fund is projected to exceed outgo until 2016, but thereafter the HI fund is projected to be depleted, and to
reach zero in 2029, nine years earlier than the OASDI
trust funds. Unlike Social Security, Medicare has never
been completely self-financed. In addition to the HI program, Medicare also consists of Supplementary Medical
Insurance (SMI), which covers medical bills outside of
the hospital. SMI is funded by a combination of premiums charged to the beneficiaries, which cover about
one-quarter of benefits, and general revenue. Even if
the HI trust fund were to remain solvent indefinitely,
Medicare as a whole would continue to be subsidized
by the rest of the budget, and as Medicare costs rise
in the future, the subsidy will increase (see accompanying box for a fuller discussion).
An Uncertain Long-Range Outlook.—At the beginning of the 1990s, when these long-run budget projections were first developed, the deficit was on an unstable trajectory. Given then-current economic projections
and policies, the deficit was projected to mount steadily
not only in dollar terms, but relative to the size of
the economy. This pattern of rising deficits would have

driven Federal debt held by the public to unsustainable
levels. Policy actions during the 1990s reduced the deficits, and the strong economy that emerged in the second half of the 1990s did even more to eliminate them.
Because of the recent economic downturn and needed
spending for defense and homeland security, the unified
budget is now projected to return to deficit for a few
years. The deficits are not large relative to the size
of the overall economy, and if budget discipline is maintained while the economy recovers as expected, surpluses will return thereafter. Furthermore, if the policies and assumptions used for this budget are extended,
the unified budget could continue in surplus into the
next decade or even later. Eventually, however, the rising burden of entitlement spending will cause deficits
to reappear unless there are structural reforms in the
major entitlement programs. How long before these
deficits are projected to show up again depends on economic and technical factors and policy decisions affecting the rest of the budget. Future stress on the budget
appears to be unavoidable absent major reforms to the
entitlement programs.
There is a wide range of uncertainty around any such
long-range projections. As discussed further below, the
projections are affected by many hard-to-foresee eco-

43

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

nomic and demographic factors, as well as by future
policy decisions. In the ten years since OMB first began

to experiment with such projections, the long-run outlook has varied considerably.

Chart 3-4. The Wide Range of Projected
Federal Deficits and Surpluses
Surplus(+)/deficit(-) percent of GDP

6

All projections assume discretionary
spending increases with GDP.

4
2

2002
Budget

0

2000
Budget

-2
2003 Budget

2001
Budget

-4
1998 Budget

-6
1996 Budget

1980

1990

2000

2010

Economic and Demographic Assumptions.—Even
though any such forecast is highly uncertain, long-run
budget projections require starting with specific economic and demographic projections. The assumptions
used as a starting point extend the Administration’s
medium-term economic projections used in preparing
this budget augmented by the long-run demographic
projections from the 2001 Social Security Trustees’ Report.
• Inflation, unemployment and interest rates hold
stable at 2.3 percent per year for CPI inflation,
4.9 percent for the unemployment rate, and 5.3
percent for the yield on 10-year Treasury notes.
• Productivity growth as measured by real GDP per
hour continues at the same constant rate as in
the Administration’s medium-term projections—
2.1 percent per year. (See chapter 2 for more detail on the Administration’s economic assumptions).
• In line with the current projections of the Social
Security Trustees, U.S. population growth is expected to slow from over 1 percent per year in
the 1990s to about half that rate by 2030, and
even less in the decades after 2030.

2020

2030

2040

2050

• The labor force participation rate declines as the
population ages and the proportion of retirees in
the population is projected to increase.
• Real GDP growth declines gradually after 2011
from 3.1 percent per year to an average annual
rate of 2.4 percent, reflecting the effects of the
projected slowdown in labor force growth combined
with the assumed constant rate of productivity
growth.
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.
Alternative Budget Projections.—These long-run
projections generally assume that mandatory spending
proceeds according to current law and that the policy
proposals in the budget are adopted without assuming
any other new programs or enhancements to existing
programs. For the reasons discussed above, these assumptions imply that the major entitlement programs
are projected to absorb an increasing share of budget
resources. This is true under all likely assumptions re-

44

ANALYTICAL PERSPECTIVES

garding future discretionary spending. Chart 3–5 shows
budget projections under the two main alternative assumptions that OMB has used in projecting discretionary spending: one holds discretionary spending constant in real dollars allowing it to increase only with
the rate of inflation while the other holds discretionary
spending constant in relation to GDP, which means
it expands at the same rate over time as GDP is projected to grow.
• Social Security benefits, driven by the retirement
of the baby-boom generation, rise from 4.2 percent
of GDP in 2001 to 6.4 percent in 2040. They continue to rise after that but more gradually, eventually reaching 6.9 percent of GDP by 2075.6

• Medicare outlays expand quite rapidly, rising from
2.1 percent of GDP in 2001 to 4.8 percent of GDP
in 2040, and 7.7 percent by 2075.
• Federal Medicaid spending goes up from 1.3 percent of GDP in 2001 to 2.7 percent in 2040 and
to 3.6 percent of GDP in 2075.
• Holding discretionary spending constant in real
dollars implies that it declines relative to GDP
from 6.5 percent in 2001 to 3.7 percent in 2040,
and to 2.1 percent in 2075. Alternatively, if discretionary spending is fixed as a share of GDP at
the level reached in 2012, it maintains a constant
5.8 percent share of GDP through 2075.

Chart 3-5. Long-Run Budget Projections
Surplus(+)/deficit(-) as a percent GDP

5
Discretionary Grows
with Inflation

0

-5
Discretionary Grows
with GDP

-10

-15
1980 1990 2000 2010 2020 2030 2040 2050 2060 2070

6 These benefit estimates reflect the economic assumptions described above, which differ
somewhat from the assumptions in the Social Security Trustees’ Report. The benefit estimates were prepared by the Social Security actuaries using OMB economic assumptions.

45

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

Table 3–2.

LONG-RUN BUDGET PROJECTIONS OF 2003 BUDGET POLICY
(Percent of GDP)
2000

Discretionary Grows with GDP
Receipts .........................................................................
Outlays .........................................................................
Discretionary ............................................................
Mandatory ................................................................
Social Security .....................................................
Medicare ..............................................................
Medicaid ..............................................................
Other ....................................................................
Net Interest ..............................................................
Surplus or Deficit (-) ....................................................
Primary Surplus or Deficit (-) ......................................
Federal Debt Held by the Public .................................
Discretionary Spending Grows with Inflation
Receipts ........................................................................
Outlays .........................................................................
Discretionary ............................................................
Mandatory ................................................................
Social Security .....................................................
Medicare ..............................................................
Medicaid ..............................................................
Other ....................................................................
Net Interest ..............................................................
Surplus or Deficit (-) ....................................................
Primary Surplus or Deficit (-) ......................................
Federal Debt Held by the Public .................................

2005

2010

2020

2030

2040

2050

2075

20.8
18.4
6.3
9.8
4.2
2.0
1.2
2.4
2.3
2.4
4.7
35.0

19.2
18.7
6.9
10.3
4.2
2.1
1.5
2.4
1.6
0.5
2.1
29.2

19.2
18.0
6.2
10.7
4.4
2.3
1.8
2.3
1.1
1.2
2.2
19.1

19.2
18.4
5.8
12.5
5.4
2.9
2.2
2.0
0.1
0.8
0.9
2.9

19.4
20.4
5.8
14.4
6.3
3.9
2.4
1.8
0.2
–1.1
–0.9
4.4

19.4
22.3
5.8
15.6
6.4
4.8
2.7
1.7
0.9
–2.9
–2.0
20.9

19.6
24.3
5.8
16.5
6.4
5.5
3.0
1.6
2.0
–4.8
–2.8
46.5

19.6
32.7
5.8
19.8
6.9
7.7
3.6
1.5
7.1
–13.2
–6.1
165.2

20.8
18.4
6.3
9.8
4.2
2.0
1.2
2.4
2.3
2.4
4.7
35.0

19.2
18.7
6.9
10.3
4.2
2.1
1.5
2.4
1.6
0.5
2.1
29.2

19.2
18.0
6.2
10.7
4.4
2.3
1.8
2.3
1.1
1.2
2.2
19.1

19.2
17.6
5.1
12.5
5.4
2.9
2.2
2.0
0.0
1.7
1.7
–0.5

19.4
18.3
4.3
14.5
6.3
3.9
2.4
1.8
–0.5
1.1
0.6
–10.9

19.4
18.7
3.7
15.6
6.4
4.8
2.7
1.7
–0.6
0.8
0.2
–13.9

19.6
19.0
3.1
16.5
6.4
5.5
3.0
1.7
–0.6
0.5
–0.1
–14.6

19.6
22.5
2.1
19.9
6.9
7.7
3.6
1.6
0.5
–2.9
–2.4
12.8

The Effects of Alternative Economic and Technical Assumptions. The results discussed above are
sensitive to changes in underlying economic and technical assumptions. Some of the most important of these
alternative economic and technical assumptions and
their effects on the budget outlook are discussed below.
Each highlights one of the key uncertainties in the
outlook.
1. Health Spending: The long-range projections for
Medicare follow the latest projections of the Medicare
actuaries from the 2001 Medicare Trustees’ Report. For
many years, the Trustees’ projections included a longrun slowdown in the rate of growth of real per capita
Medicare spending. Recently, the Technical Review
Panel on the Medicare Trustees’ Reports recommended
raising the long-run projected growth rate in real per
capita Medicare costs, so that ‘‘age-and gender-adjusted,
per-beneficiary spending growth exceeds the growth of
per-capita GDP by 1 percentage point per year.’’ 7 This
assumption was adopted in the 2001 Medicare Trustees’
Reports, and in Chart 3–5, real per capita Medicare
benefits are assumed to rise at this rate. The effect
of this change in assumptions on the Medicare HI trust
fund’s actuarial deficiency is shown in Table 3–3.
Eventually, the 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. ‘‘Eventually’’ could be a long way off. Improved
health and increased longevity are highly valued, and
society may be willing to spend a larger share of income
on them than it has heretofore. There are many reason7 Technical Review Panel on the Medical Trustees’ Reports, ‘‘Review of Assumptions and
Methods of the Medicare Trustees’ Financial Projections,’’ December 2000.

able alternative health cost and usage projections, as
well as variations in the demographic projections to
which they can be applied. Innovations in health care
are proceeding rapidly, and they have diverse effects
on the projection of costs. Likewise, the effects of greater longevity on Medicare and especially Medicaid costs
are uncertain.
2. Discretionary Spending: The assumption used to
project discretionary spending is essentially arbitrary,
because discretionary spending is determined annually
through the legislative process, and no formula can dictate future spending in the absence of legislation. Alternative assumptions have been made for discretionary
spending. Holding discretionary spending unchanged in
real terms is the ‘‘current services’’ assumption often
used for budget projections when there is no legislative
guidance on future spending levels. Alternatively, if discretionary spending is assumed to keep pace with the
growth in GDP, spending increases in real terms whenever there is positive real economic growth.
Under the assumption that future spending expands
with the size of the economy, these long-run budget
projections show clearly that the budget is on an
unsustainable path, although the shortfall unfolds only
gradually. For most of the next two decades, the budget
is projected to be in surplus, between 0 and 1-1/2 percent of GDP. In the following decade, the budget returns to deficit, and in the decade 2030–2039, the deficit begins to rise sharply. This is the time span within
which the actuaries are now projecting that the Social
Security trust funds will be exhausted. Timely action
now could resolve these problems, without disrupting
the retirement plans of future generations of workers.

46

ANALYTICAL PERSPECTIVES

3. Productivity: The future rate of productivity growth
is perhaps the most powerful of the assumptions affecting the long-run budget outlook, and it is especially
uncertain. Productivity in the U.S. economy slowed
markedly and unexpectedly after 1973. This slowdown
was responsible for a slower rise in U.S. real incomes
for the next two decades which had many profound
consequences for society. This slowdown in income
growth also contributed to worsening Federal budget
outcomes that followed 1973. In the latter half of the
1990s, however, productivity growth increased, unexpectedly again, although reasons for the revival are
clear in hindsight.
Since the end of 1995, labor productivity in the economy’s nonfarm business sector has grown at an annual
rate of 2.4 percent, a full percentage point faster than
the growth rate from 1973 through 1995, although the
latest data, which were revised last summer, show that
the trend growth rate remains about half a percentage
point slower than from 1948 though 1973. So, productivity growth has rebounded, but it has not completely
recovered from the post-1973 slowdown. On the other
hand, while the latest downturn in the economy has
cut into productivity growth, the underlying trend remains strong, which means there is reason to hope
the improvement in productivity marks a permanent
change.
The revival of productivity growth is one of the most
welcome developments of the last several years. From
a budgetary standpoint, a higher rate of economic
growth makes the task of reaching a balanced budget
much easier, while a lower productivity growth rate
has the opposite effect. Although the long-run growth
rate of productivity is inherently uncertain, it has averaged around 2 percent per year since 1947. In these
extended projections, real GDP per hour is assumed
to grow at 2.1 percent per year.
4. Population: The key assumptions underlying the
long-run demographic projections concern fertility, immigration, and mortality.
• The demographic projections assume that fertility
will average around 1.9 births per woman in the
future, slightly below the replacement rate needed
to maintain a constant population.

• The rate of immigration is assumed to average
around 900,000 per year in these projections.
Higher immigration relieves some of the pressure
on population from low fertility and means that
total population continues to expand throughout
the projection period, although at a slower rate
than historically.
• Mortality is projected to decline. The average female lifespan is projected to rise from 79.6 years
to 85.0 years by 2075, and the average male lifespan is projected to increase from 74.0 years in
2001 to 80.9 years by 2075, and the gap between
men’s and women’s expected lifespans narrows
somewhat. A technical panel to the Social Security
Trustees recently reported that the improvement
in longevity might even be greater than this. If
so, the projected growth of the three big entitlement programs would be even faster.
Conclusion.—Since the early 1990s, the long-run
budget outlook has improved significantly, but it remains highly uncertain. Currently, there is an extended
period of budget surpluses under most projection assumptions, but how big the surpluses will be and how
long they will last remain quite uncertain. Furthermore, these surpluses eventually end under most assumptions. With pessimistic assumptions, the fiscal picture deteriorates relatively soon. More optimistic assumptions imply a longer period before the inexorable
pressures of rising entitlement spending overwhelm the
budget. Fundamental reforms are needed to preserve
the basic promises embodied in Social Security and
Medicare. Meanwhile, the wide range of possible outcomes highlights the sensitivity of these long-term projections to specific assumptions and cautions against
undue reliance on any particular projection path. While
actual experience with these projections is too short
to have provided a meaningful track record to judge
their accuracy, the shifts from one budget to the next
in the featured projection path offer one indication of
the wide range of variation in reasonable outcomes (see
chart 3–4).

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 budget projections do rely on the Social Security assumptions for population growth and labor force growth after
the year 2012. Despite 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) that
would be needed to preserve a small positive balance
in the trust fund at the end of 75 years. Table 3–3
shows the changes in the 75-year actuarial balances
of the Social Security and Medicare HI trust funds from
2000 to 2001. There was virtually no change in the
consolidated OASDI trust fund’s projected deficiency.
It narrowed slightly from –1.89 percent of payroll to

47

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

–1.86 percent. There was a large change in the actuarial balance of the HI trust fund.
The changes were due to revisions in the actuarial
assumptions and to the annual shift in the valuation
period, which arises because with the passage of time
one more year of projected deficits has moved into the
75-year window. In the case of the OASDI funds, a
small improvement in the economic assumptions was

offset by the shift in the valuation period. For the HI
program, the Trustees adopted the recommendation of
their technical panel and increased the growth rate
projected for the program’s real per capita benefits.
This change in assumptions brings projected future
growth more in line with past patterns of growth, but
if the new assumption is realized it will seriously undermine the program’s long-term financial status.

Table 3–3. CHANGE IN 75-YEAR ACTUARIAL BALANCE FOR OASDI
AND HI TRUST FUNDS (INTERMEDIATE ASSUMPTIONS)
(As percent of taxable payroll)
OASI

DI

OASDI

HI

Actuarial balance in 2000 Trustees’ Report .................
Changes in balance due to changes in:.
Legislation ....................................................................
Valuation period ...........................................................
Economic and demographic assumptions ...................
Technical and other assumptions ...............................

–1.53

–0.37

–1.89

–1.21

0.00
–0.06
0.10
–0.04

0.00
–0.01
0.01
0.04

0.00
–0.07
0.11
0.00

–0.03
–0.04
0.08
–0.77

Total Changes .........................................................
Actuarial balance in 2001 Trustees’ Report .................

–0.01
–1.53

0.04
–0.33

0.03
–1.86

–0.76
–1.97

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 its taxes, but they are not owned by the Federal
Government and would not show up on a conventional
balance sheet for the Federal Government. It is true,
of course, that by encouraging economic growth in the
private sector, the Government augments future Federal tax receipts; when the private economy expands,
the Government collects more taxes. However, if the
investments funded, but not owned by the Federal Government, earn a conventional economic rate of return,
the fraction of that return that comes back to the Government in higher taxes is far less than what a private
investor would require before undertaking a similar investment.
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. None-

theless, such hypothetical capital stocks are obviously
not owned by the Federal Government, nor would they
appear on a typical balance sheet as a Government
asset, even though these investments may contribute
to future tax receipts.
To show the importance of these kinds of issues,
Table 3–4 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 7 percent of total national wealth. This may seem like a small fraction,
but it represents a large volume of capital more than
$5 trillion. The Federal contribution is down from
around 9 percent in the mid-1980s, and from around
11 percent in 1960. Much of this reflects the shrinking
size of defense capital stocks, which have declined from
around 12 percent of GDP to 7 percent since the end
of the Cold War.

48

ANALYTICAL PERSPECTIVES

Table 3–4.

NATIONAL WEALTH

(As of the end of the fiscal year, in trillions of 2001 dollars)
1960

1965

1970

1975

1980

1985

1990

1995

1999

2000

2001

2.0
1.2
1.0
0.1
0.9
0.7

2.3
1.2
1.0
0.2
1.1
0.7

2.8
1.4
1.1
0.3
1.5
0.6

3.5
1.5
1.0
0.5
2.0
0.8

3.6
1.4
0.9
0.5
2.2
1.3

3.9
1.7
1.0
0.7
2.1
1.4

4.2
1.8
1.1
0.8
2.4
1.1

4.7
2.0
1.1
0.8
2.7
0.8

5.1
2.0
1.0
0.9
3.2
0.9

5.3
1.9
1.0
1.0
3.3
1.1

5.2
2.0
1.0
1.0
3.2
1.2

2.7

3.0

3.5

4.3

4.9

5.2

5.3

5.5

6.0

6.4

6.4

7.0
2.7
2.8
0.6
0.9
2.0

8.1
3.2
3.2
0.7
1.0
2.4

9.9
3.7
4.0
0.8
1.3
2.8

12.6
4.8
5.3
1.1
1.5
3.7

16.4
6.6
6.8
1.3
1.7
5.6

17.3
6.8
7.4
1.2
1.9
6.4

19.6
7.7
8.3
1.3
2.3
6.5

21.4
8.6
9.0
1.4
2.4
4.9

24.6
10.1
10.3
1.5
2.7
6.6

25.6
10.5
10.8
1.5
2.8
7.4

26.4
11.0
11.1
1.4
2.9
7.8

9.1

10.5

12.7

16.3

22.0

23.7

26.1

26.2

31.1

33.0

34.3

0.1
6.1

0.1
7.8

0.2
10.6

0.3
13.1

0.5
17.1

0.6
20.4

0.8
26.3

0.9
29.0

1.1
35.1

1.1
36.6

1.2
37.9

ASSETS
Publicly Owned Physical Assets:
Structures and Equipment ............................................................................................................................
Federally Owned or Financed ................................................................................................................
Federally Owned .................................................................................................................................
Grants to State & Local Govt’s ..........................................................................................................
Funded by State & Local Govt’s ............................................................................................................
Other Federal Assets ..................................................................................................................................
Subtotal ....................................................................................................................................................
Privately Owned Physical Assets:
Reproducible Assets ....................................................................................................................................
Residential Structures .............................................................................................................................
Nonresidential Plant & Equipment ..........................................................................................................
Inventories ...............................................................................................................................................
Consumer Durables ................................................................................................................................
Land .............................................................................................................................................................
Subtotal ....................................................................................................................................................
Education Capital:
Federally Financed ......................................................................................................................................
Financed from Other Sources .....................................................................................................................
Subtotal ....................................................................................................................................................
Research and Development Capital:
Federally Financed R&D: ............................................................................................................................
R&D Financed from Other Sources ...........................................................................................................

6.2

7.9

10.8

13.4

17.5

21.0

27.1

29.8

36.2

37.7

39.1

0.2
0.1

0.3
0.2

0.5
0.3

0.5
0.4

0.6
0.5

0.7
0.7

0.8
0.9

0.9
1.1

1.0
1.4

1.0
1.5

1.0
1.4

Subtotal ....................................................................................................................................................

0.3

0.5

0.8

0.9

1.1

1.3

1.7

2.0

2.4

2.5

2.4

Total Assets .....................................................................................................................................................
Net Claims of Foreigners on U.S. (+) ..............................................................................................................
Net Wealth ........................................................................................................................................................

18.3
–0.1
18.4

21.9
–0.2
22.1

27.8
–0.2
27.9

34.9
–0.1
35.0

45.5
–0.4
45.8

51.3
0.0
51.2

60.2
0.8
59.4

63.6
1.5
62.0

75.7
3.5
72.2

79.5
3.5
76.0

82.1
3.5
78.6

ADDENDA:.
Per Capita Wealth (thousands of dollars) ......................................................................................................
Ratio of Wealth to GDP (in percent) ..............................................................................................................
Total Federally Funded Capital (trillions 2001 $) ...........................................................................................
Percent of National Wealth .............................................................................................................................

101.9
703.3
2.1
11.4

114.0
715.3
2.4
10.7

136.4
695.0
2.7
9.8

162.4
695.6
3.2
9.1

200.9
678.8
3.7
8.1

214.5
673.6
4.3
8.5

237.1
662.6
4.5
7.6

232.5
682.8
4.5
7.3

258.3
677.3
4.9
6.8

268.6
689.1
5.1
6.8

274.6
711.2
5.3
6.7

Physical Assets:
The physical assets in the table include stocks of
plant and equipment, office buildings, residential structures, land, and the Government’s physical assets such
as military hardware and highways. Automobiles and
consumer appliances are also included in this category.
The total amount of such capital is vast, around $41
trillion in 2001, consisting of $34 trillion in private
physical capital and $6 trillion in public physical capital; by comparison, GDP was about 10 trillion in 2001.
The Federal Government’s contribution to this stock
of capital includes its own physical assets plus $1.1
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 formal edu-

cation and training. 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 at
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 for the current
value of the investment in education. According to this
measure, the stock of education capital amounted to
$39 trillion in 2001, of which about 3 percent was financed by the Federal Government. It is nearly equal
to the total value of the Nation’s 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
proposed. 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 about two-thirds of national in-

49

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

come, and thinking of this 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, which is
why they are referred to as education capital rather
than human capital. They are that part of human capital that can be attributed to 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.8 That stock is
estimated to have been about $2–1/2 trillion in 2001.
Although this represents a large amount of research,
it is a relatively small portion of total National wealth.
Of this stock, about 40 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. In most cases, the debts of one American are the assets of another American, so in these
cases, the debts are not included in Table 3–4 because
they are not a net liability of Americans as a Nation.
Table 3–4 is intended to show National totals only,
but that does not mean that the level of debt is unimportant. The amount of debt owed by Americans to
other Americans can exert both positive and negative
effects on the economy. American’s willingness to borrow helped fuel the expansion of the 1990s, but the
debts accumulated in this process must be serviced,
which could lead to curtailed spending at some future
point. Moreover, bad debts, which are not collectible,
can cause serious problems for the banking system.
While the banking system appears to be financially
sound, such uncollectible debts were a serious problem
hampering the opening stages of the last economic expansion in 1991–1992. Despite these considerations, the
only debts that appear in Table 3–4 are the debts
Americans owe to foreign investors. America’s foreign
debt has been increasing rapidly in recent years, because of the rising deficit in the U.S. current account.
Although the current account deficit has been at record
levels recently, the size of this debt remains small compared with the total stock of U.S. assets. It amounted
to 3–1/2 percent of total assets in 2001.
Federal debt does not appear explicitly in Table 3–4
because much of it is held by Americans; only that
portion of the Federal debt held by foreigners is included with other debt to foreigners. Comparing the
Federal Government’s net liabilities with total national
8 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.

wealth does, however, provide another indication of the
relative magnitude of the imbalance in the Government’s accounts. Currently, Federal net liabilities, as
reported in Table 3–1, amount to about 4 percent of
net U.S. wealth as shown in Table 3–4.
Trends in National Wealth
The net stock of wealth in the United States at the
end of FY 2001 was about $78–1/2 trillion, almost eight
times the level of GDP. Since 1981, it has increased
in real terms at an average annual rate of 2.6 percent
per year—two percentage points less rapidly than it
grew from 1961 to 1981—4.7 percent per year. Public
physical capital formation growth slowed even more.
Since 1981, public physical capital has increased at an
annual rate of only 1.0 percent, compared with 3.3 percent over the previous 20 years.
The net stock of private nonresidential plant and
equipment grew 2.3 percent per year from 1981 to 2001,
compared with 4.6 percent in the 1960s and 1970s;
and the stock of business inventories increased even
less, just 0.4 percent per year on average since 1981.
However, private nonresidential fixed capital has increased much more rapidly since 1995—3.8 percent per
year—reflecting the investment boom in the latter half
of the 1990s.
The accumulation of education capital, as measured
here, has also slowed down since 1981, but not as
much. It grew at an average rate of 5.3 percent per
year in the 1960s and 1970s, about 0.9 percentage point
faster than the average rate of growth in private physical capital during the same period. Since 1981, education capital has grown at a 3.9 percent annual rate.
This reflects both the extra resources devoted to schooling in this period, and the fact that such resources
were increasing in economic value. R&D stocks have
also grown at about 3.9 percent per year since 1981.
Other Federal Influences on Economic Growth
Federal investment decisions, as reflected in Table
3–4, obviously are important, but the Federal Government also contributes to wealth in ways that cannot
be easily captured in a formal presentation. The Federal Reserve’s monetary policy affects the rate and direction of capital formation in the short run, and Federal regulatory and tax policies also affect how capital
is invested, as do the Federal Government’s policies
on credit assistance and insurance.
Social Indicators
There are certain broad responsibilities that are
unique to the Federal Government. Especially important are fostering healthy economic conditions including
sound economic growth, promoting health and social
welfare, and protecting the environment. Table 3–5 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

50

ANALYTICAL PERSPECTIVES

Table 3–5.
General categories

Economic:
Living Standards ...........

Economic Security ........
Employment ..................

Wealth Creation ...............
Innovation .....................
Environment:.
Air Quality .....................

Water Quality ................
Social:
Families .........................

ECONOMIC AND SOCIAL INDICATORS

Specific measures

Real GDP per person (1996 dollars) .................................
average annual percent change (5-year trend) .................
Median Income (2000 dollars):
All Households ...............................................................
Married Couple Families ................................................
Female Householder, Husband Absent .........................
Income Share of Lower 60% of All Families ................
Poverty Rate (%) (a) ......................................................
Civilian Unemployment (%) ................................................
CPI-U (% Change) .............................................................

1960

1965

1970

1975

1980

1985

1990

1995

1999

2000

2001

$13,145
0.7

$15,587
3.5

$17,445
2.3

$18,909
1.6

$21,523
2.6

$23,971
2.2

$26,832
2.3

$28,318
1.1

$31,732
2.6

$32,651
2.9

$32,572
2.4

N/A
$29,111
$14,712
34.8
22.2
5.5
1.7

N/A
$33,881
$16,472
35.2
17.3
4.5
1.6

$33,746
$40,631
$19,678
35.2
12.6
4.9
5.8

$33,489
$42,193
$19,423
35.2
12.3
8.5
9.1

$35,238
$46,045
$20,709
34.5
13.0
7.1
13.5

$36,246
$47,728
$20,964
32.7
14.0
7.2
3.5

$38,446
$51,224
$21,740
32.0
13.5
5.5
5.4

$38,262
$52,843
$22,110
30.3
13.8
5.6
2.8

$42,187
$58,580
$24,529
29.8
11.8
4.2
2.1

$42,148
$59,187
$25,787
29.6
11.3
4.0
3.4

N/A
N/A
N/A
N/A
N/A
4.8
2.9

Increase in Total Payroll Employment Previous 12
Months.
Managerial or Professional Jobs (% of civilian employment) ...............................................................................
Net National Saving Rate (% of GDP) ..............................

–0.5

2.9

–0.5

0.4

0.2

2.5

0.3

2.2

3.1

2.0

–1.1

N/A
10.2

N/A
12.1

N/A
8.2

N/A
6.6

N/A
7.5

24.1
6.1

25.8
4.6

28.3
4.7

30.3
6.0

30.2
5.6

31.0
4.0

Patents Issued to U.S. Residents (thousands) .................
Multifactor Productivity (average annual percent change)

42.3
0.8

54.1
2.8

50.6
0.8

51.5
1.1

41.7
0.8

45.1
0.6

56.1
0.5

68.2
0.6

99.5
1.0

103.6
N/A

N/A
N/A

Nitrogen Oxide Emissions (thousand short tons) ..............
Sulfur Dioxide Emissions (thousand short tons) ...............
Lead Emissions (thousand short tons) ..............................

14,140
22,227
N/A

16,579
26,750
N/A

20,928
31,161
221

22,632
28,011
160

24,384
25,905
74

23,198
23,658
23

24,170
23,678
4

25,051
19,188
4

25,393
18,867
4

N/A
N/A
N/A

N/A
N/A
N/A

Population Served by Secondary Treatment or Better
(mils) ...............................................................................

N/A

N/A

N/A

N/A

N/A

134

155

166

N/A

N/A

N/A

Children Living with Mother Only (% of all children) ........

9.2

10.2

11.6

16.4

18.6

20.2

21.6

24.0

22.4

21.7

N/A

Safe Communities ........

Violent Crime Rate (per 100,000 population) (b) ..............
Murder Rate (per 100,000 population) (b) ........................
Murders (per 100,000 Persons Age 14 to 17) ..................

160
5
N/A

199
5
N/A

364
8
N/A

482
10
5

597
10
6

557
8
5

732
9
10

685
8
11

523
6
6

506
6
N/A

N/A
N/A
N/A

Health ............................

Infant Mortality (per 1000 Live Births) ...............................
Low Birthweight [<2,500 gms] Babies (%) ........................
Life Expectancy at birth (years) .........................................
Cigarette Smokers (% population 18 and older) ...............

26.0
7.7
69.7
N/A

24.7
8.3
70.2
41.9

20.0
7.9
70.8
39.2

16.1
7.4
72.6
36.3

12.6
6.8
73.7
33.0

10.6
6.8
74.7
29.9

9.2
7.0
75.4
25.3

7.6
7.3
75.8
24.6

7.1
7.6
76.7
23.3

6.9
7.6
76.9
N/A

N/A
N/A
N/A
N/A

Learning ........................

High School Graduates (% of population 25 and older) ..
College Graduates (% of population 25 and older) ..........
National Assessment of Educational Progress (c)
Mathematics High School Seniors .................................
Science High School Seniors ........................................

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

83.4
25.2

N/A
N/A

N/A
N/A

N/A
N/A

N/A
N/A

N/A
305

302
293

299
286

301
288

305
290

307
295

308
295

N/A
N/A

N/A
N/A

Individual Charitable Giving per Capita (2000 dollars) .....
(by presidential election year)
Voting for President (% eligible population) ......................

231
(1960)
62.8

277
(1964)
61.9

333
(1968)
60.9

353
(1972)
55.2

385
(1976)
53.5

396
(1980)
52.8

439
(1984)
53.3

416
(1988)
50.3

553
(1992)
55.1

554
(1996)
49.0

N/A
(2000)
51.2

Participation ..................

N/A = Not Available.
(a) The poverty rate does not reflect noncash government transfers such as Medicaid or food stamps.
(b) Not all crimes are reported, and the fraction that go unreported may have varied over time, 2000 data are preliminary.
(c) Some data from the national educational assessments have been interpolated.

the United States. In choosing indicators for this table,
priority was given to measures that were consistently
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 generally
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. The Government cannot avoid making such
trade-offs 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.
It is worth noting that, in recent years, many of
the trends in these indicators turned around. The improvement in economic conditions has been widely
noted, and there have also been some significant social
improvements. Perhaps, most notable has been the
turnaround in the crime rate. Since reaching a peak

51

3. STEWARDSHIP: TOWARD A FEDERAL BALANCE SHEET

in the early 1990s, the violent crime rate has fallen
by a third. The turnaround has been especially dramatic in the murder rate, which was lower in 2000
than at any time since the 1960s. The recession that
began in March 2001 is having an effect on some of
these indicators already, and could affect others when
data become available later this year. Unemployment
has risen and real GDP growth has declined. But if
the recession is brief, which is the expectation for this
budget, much of the improvement shown in Table 3–5
is likely to be preserved.

An Interactive Analytical Framework
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.

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.
Physical Assets:
Fixed Reproducible Capital: Estimates were developed from the OMB historical data base for physical
capital outlays and software purchases. 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 dollars, it was necessary to deflate
the nominal investment series. This was done using
price deflators for Federal investment 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 from the Agriculture Department for farm land;
the value of Federal oil deposits was extrapolated using
the Producer Price Index for Crude Energy Materials.
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
Pension Guarantee Model and OMB estimates based
on program data. Historical data on liabilities for deposit insurance were also drawn from CBO’s study, The
Economic Effects of the Savings and Loan Crisis, issued
January 1992.
Pension Liabilities: For 1979–1998, 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). Es-

timates for the years before 1979 are extrapolations.
The estimate for 2001 is a projection. The health insurance liability was estimated by the program actuaries
for 1997–2001, and extrapolated back for earlier years.
Long-Run Budget Projections
The long-run budget projections are based on longrun demographic and economic assumptions. A simplified model of the Federal budget, developed at OMB,
computes the budgetary implications of these projections.
Demographic and Economic Projections: For the years
2002–2012, the assumptions are identical to those used
in the budget. These budget assumptions reflect the
President’s policy proposals. The economic assumptions
in the budget are extended 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 2001 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: 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 to grow at the rate
of inflation or at the rate of growth in nominal GDP.
Social Security is projected by the Social Security actuaries using these long-range assumptions. Federal pensions are derived from the most recent actuarial forecasts available at the time the budget is prepared, repriced using Administration inflation assumptions.
Medicaid outlays are based on the economic and demographic projections in the model. Medicare projections
follow the latest Medicare Trustees’ reports adjusted
for the Administration’s different inflation and real
growth assumptions. Other entitlement programs are
projected based on rules of thumb linking program

52

ANALYTICAL PERSPECTIVES

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 Federal investment flows described in Chapter
7. Federal grants for State and local Government capital are 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 extrapolated for 2001.
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 extrapolated for 2001 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. Estimates of students’
forgone earnings are 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 because
these outlays are classified elsewhere as investment
in physical 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 implicit
price deflator for GDP to convert them to constant dol-

lar 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. 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
price index 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 estimated stock of applied research and
development. Basic research is assumed not to depreciate. Chapter 7 of this volume contains additional details on the estimates of the total federally financed
R&D stock, as well as its national defense and nondefense components.
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 3–4 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. The data are all publicly available, and can be found in such general sources
as the annual Economic Report of the President and
the Statistical Abstract of the United States, or from
agencies’ Web sites.

FEDERAL RECEIPTS AND COLLECTIONS

53

4.

FEDERAL RECEIPTS

Receipts (budget and off-budget) are taxes and other
collections from the public that result from the exercise
of the Federal Government’s sovereign or governmental
powers. The difference between receipts and outlays
determines the surplus or deficit.
The Federal Government also collects income from
the public from market-oriented activities. Collections
from these activities, which are subtracted from gross
outlays, rather than added to taxes and other governmental receipts, are discussed in the following chapter.
Growth in receipts.—Total receipts in 2003 are estimated to be $2,048.1 billion, an increase of $101.9 bil-

Table 4–1.

lion or 5.2 percent relative to 2002. Receipts are projected to grow at an average annual rate of 5.9 percent
between 2003 and 2007, rising to $2,571.7 billion. This
growth in receipts is largely due to assumed increases
in incomes resulting from both real economic growth
and inflation.
As a share of GDP, receipts are projected to decline
from 19.6 percent in 2001 to 18.8 percent in 2002 and
2003. The receipts share of GDP is projected to increase
to 19.1 percent in 2007, despite the phasein of legislated tax reductions and the President’s proposed tax
plan.

RECEIPTS BY SOURCE—SUMMARY
(In billions of dollars)
Estimate

Source

2001 actual
2002

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 ....................................................................
Bipartisan economic security plan ..................................................
Total receipts .........................................................................
(On-budget) .........................................................................
(Off-budget) .........................................................................

Table 4–2.

994.3
151.1
694.0
(186.4)
(507.5)
66.1
28.4
19.4
37.8
......................
1,991.0
(1,483.5)
(507.5)

2003

2004

2005

2006

2007

949.2
201.4
708.0
(190.8)
(517.2)
66.9
27.5
18.7
36.4
–62.0

1,006.4
205.5
749.2
(203.9)
(545.3)
69.0
23.0
19.8
40.2
–65.0

1,058.6
212.0
789.8
(216.3)
(573.5)
71.2
26.6
21.9
42.8
–47.5

1,112.0
237.1
835.2
(227.0)
(608.2)
73.6
23.4
23.0
43.2
–9.5

1,157.3
241.4
868.7
(235.1)
(633.7)
75.3
26.4
24.7
44.4
17.0

1,221.7
250.6
908.3
(243.0)
(665.3)
77.5
23.2
26.2
46.2
18.0

1,946.1
(1,428.9)
(517.2)

2,048.1
(1,502.7)
(545.3)

2,175.4
(1,601.9)
(573.5)

2,338.0
(1,729.8)
(608.2)

2,455.3
(1,821.6)
(633.7)

2,571.7
(1,906.4)
(665.3)

EFFECT ON RECEIPTS OF CHANGES IN THE SOCIAL SECURITY TAXABLE EARNINGS BASE
(In billions of dollars)
Estimate

Social security (OASDI) taxable earnings base increases:.
$84,900 to $89,700 on Jan. 1, 2003 .........................................................................................................................
$89,700 to $92,400 on Jan. 1, 2004 .........................................................................................................................
$92,400 to $96,000 on Jan. 1, 2005 .........................................................................................................................
$96,000 to $99,900 on Jan. 1, 2006 .........................................................................................................................
$99,900 to $103,800 on Jan. 1, 2007 .......................................................................................................................

2003

2004

2005

2006

2.2
................
................
................
................

5.8
1.3
................
................
................

6.4
3.3
1.7
................
................

7.0
3.6
4.5
1.9
................

2007

7.7
3.9
4.9
4.9
1.9

55

56

ANALYTICAL PERSPECTIVES

ENACTED LEGISLATION
Several laws were enacted in 2001 that have an effect
on governmental receipts. The major legislative changes
affecting receipts are described below.
ECONOMIC GROWTH AND TAX RELIEF
RECONCILIATION ACT OF 2001 (EGTRRA)
From the Administration’s first day in office, President Bush worked to deliver on his campaign promise
of meaningful tax relief. Congress moved with exceptional speed and on June 7, 2001, this Act was signed
by President Bush. The major provisions of this Act,
which are described in greater detail below, create a
new 10-percent individual income tax rate bracket; reduce marginal income tax rates for individuals; eliminate the estate tax; reduce the marriage penalty; provide relief from the alternative minimum tax (AMT);
modify the timing of estimated tax payments by corporations; and modify tax benefits for children, education, and pension and retirement savings. Almost all
of the provisions phase in over a number of years and
sunset on December 31, 2010.
Individual Income Tax Relief
Create a new 10-percent individual income tax
rate bracket.—Effective for taxable years beginning
after December 31, 2000 and before January 1, 2011,
the prior law 15-percent individual income tax rate
bracket is split into two tax rate brackets of 10 and
15 percent. The new 10-percent tax rate bracket applies
to the first $6,000 of taxable income for single taxpayers and married taxpayers filing separate returns
(increasing to $7,000 for taxable years beginning after
December 31, 2007), the first $10,000 of taxable income
for heads of household, and the first $12,000 of taxable
income for married taxpayers filing a joint return (increasing to $14,000 of taxable income for taxable years
beginning after December 31, 2007). Taxable income
above these thresholds that was taxed at the 15-percent
rate under prior law will continue to be taxed at that
rate. The income thresholds for the new tax rate bracket will be adjusted annually for inflation, effective for
taxable years beginning after December 31, 2008 and
before January 1, 2011.
For 2001, most taxpayers received the benefit of the
new 10-percent tax rate bracket through an advanced
credit, issued by the Department of Treasury in the
form of a check. The amount of the advanced credit
was equal to 5 percent of taxable income reported on
tax returns filed for 2000, up to a maximum credit
of $300 for single taxpayers and married taxpayers filing separate returns, $500 for heads of household, and
$600 for married taxpayers filing a joint return. Taxpayers are entitled to a similar credit on tax returns
filed for 2001 to the extent that it exceeds the advanced
credit, if any, that they received on the basis of tax
returns filed for 2000.

Reduce individual income tax rates.—In addition
to splitting the 15-percent tax rate bracket of prior
law into two tax rate brackets (see preceding discussion), this Act replaces the four remaining statutory
individual income tax rate brackets of prior law (28,
31, 36, and 39.6 percent) with a rate structure of 25,
28, 33, and 35 percent. The reduced tax rate structure
is phased in over a period of six years, effective for
taxable years beginning after December 31, 2000, as
follows: the 28-percent rate is reduced to 27.5 percent
for 2001, 27 percent for 2002 and 2003, 26 percent
for 2004 and 2005, and 25 percent for 2006 through
2010; the 31 percent rate is reduced to 30.5 for 2001,
30 percent for 2002 and 2003, 29 percent for 2004 and
2005, and 28 percent for 2006 through 2010; the 36
percent rate is reduced to 35.5 percent for 2001, 35
percent for 2002 and 2003, 34 percent for 2004 and
2005, and 33 percent for 2006 through 2010; and the
39.6 percent rate is reduced to 39.1 percent for 2001,
38.6 percent for 2002 and 2003, 37.6 percent for 2004
and 2005, and 35 percent for 2006 through 2010. The
income thresholds for these tax rate brackets are adjusted annually for inflation as provided under prior
law.
Repeal phaseout of personal exemptions.—Under
prior law, the deduction for taxpayer and dependent
personal exemptions ($2,900 for taxable year 2001),
began to be phased out for taxpayers with adjusted
gross income (AGI) over certain thresholds (for taxable
year 2001, the thresholds were $132,950 for single taxpayers, $166,200 for heads of household, $99,725 for
married taxpayers filing separate returns, and $199,450
for married taxpayers filing a joint return). For taxable
year 2001, the deduction for personal exemptions was
fully phased out above AGI of $255,450 for single taxpayers, $288,700 for heads of household, $160,975 for
married taxpayers filing separate returns, and $321,950
for married taxpayers filing a joint return. This Act
phases in the repeal of the phaseout of personal exemptions over a five-year period, effective for taxable years
beginning after December 31, 2005. The otherwise applicable personal exemption phaseout is reduced by onethird for taxable years 2006 and 2007, is reduced by
two-thirds for taxable years 2008 and 2009, and is repealed for taxable year 2010.
Repeal limitation on itemized deductions.—
Under prior law, the amount of otherwise allowable
itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and wagering losses) was reduced by three percent of AGI in
excess of certain thresholds (for taxable year 2001, the
thresholds were $66,475 for married taxpayers filing
separate returns and $132,950 for all other taxpayers).
This Act phases in the repeal of the limitation on
itemized deductions over a five-year period, effective
for taxable years beginning after December 31, 2005.
The otherwise applicable limitation on itemized deduc-

4.

FEDERAL RECEIPTS

tions is reduced by one-third for taxable years 2006
and 2007, is reduced by two-thirds for taxable years
2008 and 2009, and is repealed for taxable year 2010.
Tax Benefits for Children
Increase and expand the child tax credit.—Under
prior law, taxpayers were provided a tax credit of up
to $500 for each qualifying child under the age of 17.
This Act doubles the maximum amount of the credit
to $1,000 over a 10-year period, effective for taxable
years beginning after December 31, 2000. The credit
increases to $600 for taxable years 2001 through 2004,
$700 for taxable years 2005 through 2008, $800 for
taxable year 2009, and $1,000 for taxable year 2010.
Generally, the credit was nonrefundable under prior
law; however, taxpayers with three or more qualifying
children could be eligible for an additional refundable
child tax credit if they had little or no individual income
tax liability. The additional credit could be offset
against social security payroll tax liability, provided
that liability exceeded the refundable portion of the
earned income tax credit (EITC). Under this Act, the
child credit is refundable to the extent of 10 percent
of the taxpayer’s earned income in excess of $10,000
for taxable years 2001 through 2004. The percentage
increases to 15 percent for taxable years 2005 through
2010. The $10,000 earned income threshold is indexed
annually for inflation beginning in 2002. Families with
three or more children are allowed a refundable credit
for the amount by which their social security payroll
taxes exceed their earned income credit (the prior law
rule), if that amount is greater than the refundable
credit based on their earned income in excess of
$10,000. This Act also provides that the refundable portion of the child credit does not constitute income and
shall not be treated as resources for purposes of determining eligibility or the amount or nature of benefits
or assistance under any Federal program or any State
or local program financed with Federal funds.
Under prior law, beginning in taxable year 2002, the
child tax credit would have been allowed only to the
extent that an individual’s regular individual income
tax liability exceeded his or her tentative minimum
tax. In addition, beginning in taxable year 2002, the
refundable child tax credit would have been reduced
by the amount of the individual’s alternative minimum
tax. Effective for taxable years beginning after December 31, 2001 and before January 1, 2011, this Act allows the child credit to offset both the regular tax and
the alternative minimum tax; in addition, the refundable credit will not be reduced by the amount of the
alternative minimum tax.
Extend and expand adoption tax benefits.—Prior
law provided a permanent nonrefundable 100-percent
tax credit for the first $6,000 of qualified expenses incurred in the adoption of a child with special needs.
A nonrefundable 100-percent tax credit was provided
for the first $5,000 of qualified expenses incurred before
January 1, 2002 in the adoption of a child without

57
special needs. The adoption credit (including the credit
for the adoption of a child with special needs) phased
out ratably for taxpayers with modified AGI between
$75,000 and $115,000. In addition, for taxable years
beginning after December 31, 2001, the otherwise allowable adoption credit was allowed only to the extent
that the taxpayer’s regular income tax liability exceeded
the taxpayer’s tentative minimum tax. This Act increases the credit for qualified expenses incurred in
the adoption of a child, including a child with special
needs, to $10,000, effective for qualified expenses incurred after December 31, 2001 and before January
1, 2011. The $10,000 amount is indexed annually for
inflation, effective for taxable years beginning after December 31, 2002. For the adoption of a child with special needs finalized after December 31, 2002 and before
January 1, 2011, the credit is provided regardless of
whether qualified adoption expenses are incurred. Effective for taxable years beginning after December 31,
2001 and before January 1, 2011, the credit (including
the credit for the adoption of a child with special needs)
phases out ratably for taxpayers with modified AGI
between $150,000 and $190,000. The start of the phaseout range is indexed annually for inflation effective for
taxable years beginning after December 31, 2002, but
the width of the phase-out range remains at $40,000.
In addition, for taxable years beginning after December
31, 2001 and before January 1, 2011, the adoption tax
credit is allowed against the alternative minimum tax.
Under prior law, up to $5,000 per child in qualified
adoption expenses paid or reimbursed by an employer
under an adoption assistance program could be excluded from the gross income of an employee. The maximum exclusion was $6,000 for the adoption of a child
with special needs. The exclusion, which applied to
amounts paid or expenses incurred before January 1,
2002, was phased out ratably for taxpayers with modified AGI (including the full amount of the employer
adoption benefit) between $75,000 and $115,000. This
Act increases the maximum exclusion to $10,000 per
child, including the adoption of a child with special
needs, effective for expenses incurred after December
31, 2001 and before January 1, 2011. The $10,000
amount is indexed annually for inflation, effective for
taxable years beginning after December 31, 2002. For
the adoption of a child with special needs finalized after
December 31, 2002 and before January 1, 2011, the
exclusion is provided regardless of whether qualified
adoption expenses are incurred. Effective for taxable
years beginning after December 31, 2001 and before
January 1, 2011, the exclusion (including the exclusion
for the adoption of a child with special needs) phases
out ratably for taxpayers with modified AGI between
$150,000 and $190,000. The start of the phase-out
range is indexed annually for inflation effective for taxable years beginning after December 31, 2002, but the
width of the phase-out range remains at $40,000.
Expand dependent care tax credit.—Under prior
law, a taxpayer could receive a nonrefundable tax credit
for a percentage of a limited amount of dependent care

58

ANALYTICAL PERSPECTIVES

expenses ($2,400 for one qualifying dependent and
$4,800 for two or more qualifying dependents) paid in
order to work. The credit rate was phased down from
30 percent of expenses (for taxpayers with AGI of
$10,000 or less) to 20 percent of expenses (for taxpayers
with AGI above $28,000). Effective for taxable years
beginning after December 31, 2002 and before January
1, 2011, this Act increases the maximum amount of
eligible employment related expenses to $3,000 for one
qualifying dependent and to $6,000 for two or more
qualifying dependents. In addition, the maximum credit
rate is increased to 35 percent for taxpayers with AGI
of $15,000 or less, and the phase down is modified
so that the 20 percent rate applies to taxpayers with
AGI above $43,000.
Provide tax credit for employer-provided child
care facilities.—A 25-percent tax credit is provided
to employers for qualified expenses incurred to build,
acquire, rehabilitate, expand, or operate a child care
facility for employee use, or to provide child care services to children of employees directly or through a third
party. A 10-percent credit is provided for qualified expenses incurred to provide employees with child care
resource and referral services. The maximum total credit for an employer may not exceed $150,000 per taxable
year, and is effective for taxable years beginning after
December 31, 2001 and before January 1, 2011. Any
deduction the employer would otherwise be entitled to
take for the expenses is reduced by the amount of the
credit. The taxpayer’s basis in a facility is reduced to
the extent that a credit is claimed for expenses of constructing, rehabilitating, expanding, or acquiring a facility; in addition, the credit is subject to recapture
for the first ten years after the qualified child care
facility is placed in service.
Marriage Penalty Relief
Increase standard deduction for married taxpayers filing a joint return.—The basic standard deduction amount for single taxpayers under prior law
was equal to 60 percent of the basic standard deduction
amount for married taxpayers filing a joint return.
Therefore, two single taxpayers had a combined standard deduction that exceeded the standard deduction of
a married couple filing a joint return. This Act increases the standard deduction for married couples filing a joint return to double the standard deduction
for single taxpayers over a five-year period, beginning
after December 31, 2004. Under the phasein, the standard deduction for married taxpayers filing a joint return
increases to 174 percent of the standard deduction for
single taxpayers in taxable year 2005, 184 percent in
taxable year 2006, 187 percent in taxable year 2007,
190 percent in taxable year 2008, and 200 percent in
taxable years 2009 and 2010.
Expand the 15-percent tax rate bracket for married taxpayers filing a joint return.—The size of
the 15-percent tax rate bracket for married taxpayers

filing a joint return is increased to twice the size of
the corresponding tax rate bracket for single taxpayers.
The increase, which is phased in over four years, beginning after December 31, 2004, is as follows: the 15percent tax rate bracket for married taxpayers filing
a joint return increases to 180 percent of the corresponding tax rate bracket for single taxpayers in taxable year 2005, 187 percent in taxable year 2006, 193
percent in taxable year 2007, and 200 percent in taxable years 2008, 2009 and 2010.
Modify the phaseout of the earned income credit
(EITC) for married taxpayers filing a joint return
and simplify the EITC.— The maximum earned income tax credit is phased in as an individual’s earned
income increases. The credit phases out for individuals
with earned income (or, if greater, modified AGI) over
certain levels. For married taxpayers filing a joint return, both the phasein and phaseout of the credit are
calculated based on the couples’ combined income.
Under this Act, for married taxpayers filing a joint
return, the income threshold at which the credit begins
to phase out is increased, effective for taxable years
beginning after December 31, 2001 and before January
1, 2011. For married taxpayers filing a joint return
the phase-out threshold increases by $1,000 for taxable
years 2002 through 2004, $2,000 for taxable years 2005
through 2007, and $3,000 for taxable years 2008
through 2010. The $3,000 amount is increased annually
for inflation beginning in taxable year 2009.
This Act also simplifies EITC eligibility criteria and
allows the Internal Revenue Service (IRS) to use more
cost efficient procedures to deny certain questionable
EITC claims. In addition, effective for taxable years
beginning after December 31, 2001 and before January
1, 2011, the prior law rule that reduced the EITC by
the amount of the alternative minimum tax is repealed.
Education Incentives
Increase and expand education savings accounts.—Under prior law, taxpayers were permitted
to contribute up to $500 per year to an education savings account (an ‘‘education IRA’’) for beneficiaries
under age 18. The contribution limit was phased out
for taxpayers with modified AGI between $95,000 and
$110,000 (between $150,000 and $160,000 for married
couples filing a joint return). Contributions to an education IRA were not deductible, but earnings on contributions were allowed to accumulate tax-free. Distributions were excludable from gross income to the
extent they did not exceed qualified higher education
expenses incurred during the year the distribution was
made. The earnings portion of a distribution not used
to cover qualified higher education expenses was included in the gross income of the beneficiary and was
generally subject to an additional 10-percent tax. If any
portion of a distribution from an education savings account was excluded from gross income, an education
tax credit could not be claimed with respect to the
same student for the same taxable year. An excise tax

4.

FEDERAL RECEIPTS

of six percent was imposed on contributions to an education IRA in any year in which contributions were
also made to a qualified State tuition program on behalf
of the same beneficiary.
Effective for taxable years beginning after December
31, 2001 and before January 1, 2011, this Act increases
the annual contribution limit to education IRAs to
$2,000 and increases the contribution phase-out range
for married couples filing a joint return to twice the
range for single taxpayers ($190,000 to $220,000 of
AGI). As under prior law, contributions to an education
IRA are not deductible, but earnings on contributions
are allowed to accumulate tax-free. In addition to allowing tax-free and penalty-free distributions for qualified
higher education expenses, this Act expands education
savings accounts to allow tax-free and penalty-free distributions for qualified elementary, secondary and after
school expenses. Qualified expenses at public, private,
and religious educational institutions providing elementary and secondary education generally include: tuition;
fees; academic tutoring; special needs services; books;
supplies; computer equipment; and certain expenses for
room and board, uniforms, and transportation. Under
this Act: (1) the rule prohibiting contributions after the
beneficiary attains age 18 does not apply in the case
of a special needs beneficiary, as defined by Treasury
Department regulations, (2) both an education tax credit and a tax-free distribution from an education savings
account are allowed with respect to the same student
in the same taxable year, provided the credit and the
distribution are not used for the same expenses, and
(3) the excise tax on contributions made to an education
IRA on behalf of a beneficiary during any taxable year
in which contributions are made to a qualifying State
tuition program on behalf of the same beneficiary is
repealed.
Allow tax-free distributions from Qualified State
Tuition Plans (QSTPs) for certain higher education expenses and allow private colleges to offer
prepaid tuition plans.—QSTP programs generally
take two forms - prepaid tuition plans and savings
plans. Under a prepaid tuition plan, an individual may
purchase tuition credits or certificates on behalf of a
designated beneficiary, which entitle the beneficiary to
the waiver or payment of qualified higher education
expenses at participating educational institutions.
Under a savings plan, an individual may make contributions to an account, which is established for the
purpose of meeting the qualified higher education expenses of a designated beneficiary. Distributions from
QSTPs for nonqualified expenses generally are subject
to a more than de minimis penalty (typically 10 percent
of the earnings portion of the distribution). There is
no specific dollar cap on annual contributions to a
QSTP; in addition, there is no limit on contributions
to a QSTP based on the contributor’s income. Contributions to a QSTP are permitted at any time during the
beneficiary’s lifetime and the account can remain open
after the beneficiary reaches age 30. However, a QSTP
must provide adequate safeguards to prevent contribu-

59
tions on behalf of a designated beneficiary in excess
of amounts necessary to provide for qualified education
expenses.
Two basic tax benefits were provided to contributions
to, and beneficiaries of, QSTPs under prior law: (1)
earnings on amounts invested in a QSTP were not subject to tax until a distribution was made (or educational
benefits were provided), and (2) distributions made on
behalf of a beneficiary were taxed at the beneficiary’s
(rather than the contributor’s) individual income tax
rate.
Effective for taxable years beginning after December
31, 2001 and before January 1, 2011, this Act provides
for tax-free withdrawals from QSTPs for qualified higher education expenses, including tuition and fees; certain expenses for room and board; certain expenses for
books, supplies, and equipment; and expenses of a special needs beneficiary that are necessary in connection
with enrollment or attendance at an eligible education
institution. An education tax credit, a tax-free distribution from an education savings account, and a tax-free
distribution from a QSTP are allowed with respect to
the same student in the same taxable year, provided
the credit and the distributions are not used for the
same expenses. Effective for taxable years beginning
after December 31, 2003 and before January 1, 2011,
this Act allows private educational institutions to establish qualified prepaid tuition plans (but not savings
plans), provided the institution is eligible to participate
in Federal financial aid programs under Title IV of
the Higher Education Act of 1965. In addition, the prior
law rule imposing a more than de minimis monetary
penalty on any refund of earnings not used for qualified
higher education expenses is repealed and replaced
with an additional 10-percent tax on any payment includible in gross income; however, effective for taxable
years beginning before January 1, 2004, the 10-percent
tax does not apply to any distribution from a private
prepaid tuition program that is includible in gross income but used for qualified higher education expenses.
Provide deduction for qualified higher education expenses.—An above-the-line deduction is provided for qualified higher education expenses, effective
for expenses paid in taxable years beginning after December 31, 2001 and before January 1, 2006. Taxpayers
with AGI less than or equal to $65,000 ($130,000 for
married taxpayers filing a joint return) are provided
a maximum deduction of $3,000 in taxable years 2002
and 2003, which increases to $4,000 in taxable years
2004 and 2005. Taxpayers with AGI greater than
$65,000 and less than or equal to $80,000 (greater than
$130,000 and less than or equal to $160,000 for married
taxpayers filing a joint return) are provided a maximum
deduction of $2,000 for taxable years 2004 and 2005.
For a given taxable year, the deduction may not be
claimed for the qualified education expenses of a student if an education tax credit is claimed for the same
student. In addition, the deduction may not be claimed
for amounts taken into account in determining the
amount excludable from income due to a distribution

60
from an education IRA or the amount of interest excludable from income with respect to education savings
bonds. A taxpayer may not claim a deduction for the
amount of a distribution from a qualified tuition plan
that is excludable from income; however the deduction
may be claimed for the amount of a distribution from
a qualified tuition plan that is not attributable to earnings.
Extend and expand exclusion for employer-provided educational assistance.—Certain amounts
paid or incurred by an employer for educational assistance provided to an employee 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, which applied to undergraduate courses beginning before January 1, 2002
under prior law, is extended to apply to courses beginning after December 31, 2001 and before January 1,
2011, and is expanded to apply to graduate courses.
Modify student loan interest deduction.—Prior
law allowed certain individuals to claim an above-theline deduction for up to $2,500 in annual interest paid
on qualified education loans, during the first 60 months
in which interest payments were required. The maximum annual interest deduction was phased out ratably
for single taxpayers with AGI between $40,000 and
$55,000 ($60,000 and $75,000 for married taxpayers
filing a joint return). The deduction did not apply to
voluntary payments, such as interest payments made
during a period of loan forbearance. Effective for interest paid on qualified education loans after December
31, 2001 and before January 1, 2011, both the limit
on the number of months during which interest paid
is deductible and the restriction that voluntary payments of interest are not deductible are repealed. In
addition, the income phase-out ranges for eligibility for
the deduction are increased to between $50,000 and
$65,000 of AGI for a single taxpayer ($100,000 and
$130,000 for married taxpayers filing a joint return).
The income phase-out ranges are adjusted annually for
inflation after 2002.
Provide tax relief for awards under certain
health education programs.—Current 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. Under this Act,
amounts received by an individual under the National
Health Service Corps Scholarship Program or the
Armed Forces Health Professions Scholarship and Financial Assistance Program may be ‘‘qualified scholarships’’ excludable from income, without regard to the
recipient’s future service obligation. This change is effective for awards received after December 31, 2001
and before January 1, 2011.

ANALYTICAL PERSPECTIVES

Modify arbitrage restrictions on tax-exempt
bonds issued by small governmental units for public schools.—To prevent tax exempt entities from
issuing more Federally subsidized tax-exempt bonds
than is necessary for the activity being financed, current law includes arbitrage restrictions limiting the
ability to profit from investment of tax-exempt bond
proceeds. In general, arbitrage profits may be earned
only during specified periods or on specified types of
investments, and, subject to limited exceptions, must
be rebated to the Federal Government. Under prior law,
governmental bonds issued by small governmental
units were not subject to the rebate. Small governmental units are defined as general purpose governmental units that issue no more than $5 million of
tax-exempt governmental bonds in a calendar year ($10
million of governmental bonds if at least $5 million
of the bonds are used to finance public schools). Effective for bonds issued after December 31, 2001 and before January 1, 2011, this Act increases to $15 million
the maximum amount of governmental bonds that
small governmental units may issue without being subject to the arbitrage rebate requirements, if at least
$10 million of the bonds are used for public schools.
Allow States to issue tax-exempt private activity
bonds for school construction.—Effective for taxable
years beginning after December 31, 2001 and before
January 1, 2011, the activities for which States may
issue tax-exempt private activity bonds is expanded to
include the construction and equipping of public school
facilities owned by private, for-profit corporations pursuant to public-private partnership agreements with a
State or local educational agency. Under such agreements the for-profit corporation constructs, rehabilitates, refurbishes or equips the school facility, which
must be operated by a public educational agency as
part of a system of public schools; ownership reverts
to the public agency when the bonds are retired.
Issuance of these bonds is subject to an annual perState volume limit of $10 per resident (a minimum
of $5 million is provided for small States); this is in
addition to the present-law private activity bond perState volume limit equal to the greater of $75 per resident or $225 million in 2002, and indexed annually
thereafter.
Estate, Gift, and Generation-Skipping Transfer
Tax Provisions
Phase out and repeal estate and generationskipping transfer taxes, and reduce gift tax
rates.—Under prior law, the unified estate and gift
tax rates on taxable transfers began at 18 percent on
the first $10,000 of cumulative taxable transfers and
reached 55 percent on cumulative transfers in excess
of $3 million. A five-percent surtax (which phased out
the benefit of the graduated rates and increased the
top marginal tax rate to 60 percent) was imposed on
cumulative transfers between $10 million and
$17,184,000. A generation-skipping transfer tax was im-

4.

61

FEDERAL RECEIPTS

posed on transfers made either directly or through a
trust or similar arrangement to a beneficiary in a generation more than one generation below that of the
transferor (a ‘‘skip person’’). Cumulative generationskipping transfers in excess of $1 million (adjusted annually for inflation after 1997) were taxed at the top
estate and gift tax rate of 55 percent.
Under this Act, estate, gift, and generation-skipping
transfer tax rates are reduced for decedents dying and
gifts made after December 31, 2001 and before January
1, 2010. Estate and generation-skipping transfer taxes
are repealed for decedents dying after December 31,
2009 and before January 1, 2011, while the maximum
tax rate on gifts made after December 31, 2009 and
before January 1, 2011 is reduced to 35 percent on
gifts in excess of a lifetime exclusion of $1 million (see
discussion of unified credit below). The reduction in
tax rates begins in 2002 with the repeal of the fivepercent surtax and the reduction of the 53 percent and
55 percent rates to 50 percent. The maximum tax rate
on estates, gifts, and generation-skipping transfers is
reduced from 50 percent in 2002 to 49 percent in 2003,
48 percent in 2004, 47 percent in 2005, 46 percent
in 2006, and 45 percent in 2007 through 2009.
Increase unified credit exemption amount.—
Under prior law, the unified credit applicable to cumulative taxable transfers by gift and at death effectively
exempted from tax transfers totaling $675,000 in 2001,
$700,000 in 2002 and 2003, $850,000 in 2004, $950,000
in 2005 and $1 million in 2006 and subsequent years.
The tax on generation-skipping transfers applied only
to cumulative transfers in excess of $1 million, adjusted
annually for inflation after 1997 ($1,060,000 in 2001).
This Act increases the unified credit effective exemption
amount for estate and gift tax purposes to $1 million
in 2002. The effective exemption amount for gift tax
purposes will remain at $1 million; however, the effective exemption amount for estate and generation-skipping transfer tax purposes will increase to $1.5 million
in 2004 and 2005, $2.0 million in 2006 through 2008,
and $3.5 million in 2009.
Reduce and modify allowance for State death
taxes paid.—A credit against the Federal estate tax
for any estate, inheritance, legacy, or succession taxes
actually paid to any State or the District of Columbia
with respect to any property included in the decedent’s
gross estate, was provided under prior law. The allowable credit was limited to the lesser of the tax paid
or a percentage of the decedent’s adjusted taxable estate (ranging from 0.8 percent of adjusted taxable estate between $40,000 and $90,000, up to 16 percent
of adjusted taxable estate in excess of $10,040,000).
This Act reduces the credit rates by 25 percent in 2002,
50 percent in 2003, and 75 percent in 2004. For 2005
through 2009, the credit is replaced by a deduction
for taxes paid.
Modify basis of property received.—Under prior
law, the basis of property passing from a decedent’s

estate generally was the fair market value of the property on the date of the decedent’s death. This step
up (or step down) in basis eliminated the recognition
of income on any appreciation of the property that occurred prior to the decedent’s death, and had the effect
of eliminating the tax benefit from any unrealized loss.
Effective for decedent’s dying after December 31, 2009
and before January 1, 2011, the basis of property passing from a decedent’s estate will be the lesser of the
adjusted basis of the decedent or the fair market value
of the property on the date of the decedent’s death.
Each decedent’s estate generally is permitted to increase the basis of assets transferred by up to a total
of $1.3 million for assets passing to any heir plus an
additional $3 million for property transferred to a surviving spouse. Nonresidents who are not U.S. citizens
are allowed to increase the basis of property by up
to $60,000. Each estate is also allowed additional basis
equal to the decedent’s unused capital loss and net
operating loss carryforwards and built-in capital losses.
Modify other provisions affecting estate, gift,
and generation-skipping transfer taxes.—Other
modifications provided in this Act: (1) expand the estate
tax exclusion for qualified conservation easements, (2)
change the generation-skipping transfer tax rules to
ensure that a taxpayer does not inadvertently lose the
benefit of the generation-skipping transfer tax exemption, and (3) expand eligibility for the payment of estate
and gift taxes in installments.
Pension and Retirement Provisions
Increase contributions to Individual Retirement
Accounts (IRAs).—There are two types of IRAs under
present law - Roth IRAs and traditional IRAs. Individuals with AGI below certain thresholds may make nondeductible contributions to a Roth IRA (deductible contributions are not allowed). The maximum allowable
annual contribution to a Roth IRA is phased out for
single taxpayers with AGI between $95,000 and
$110,000 (between $150,000 and $160,000 for married
taxpayers filing a joint return). Account earnings are
not includible in income, and qualified distributions
from a Roth IRA are tax-free. Both deductible and nondeductible contributions may be made to a traditional
IRA. Contributions to a traditional IRA are deductible
if neither the individual nor the individual’s spouse
is an active participant in an employer-sponsored retirement plan. If the individual is an active participant
in an employer-sponsored retirement plan, the deduction limit is phased out between $34,000 and $44,000
of AGI for single taxpayers (between $54,000 and
$64,000 of AGI for married taxpayers filing a joint return). If the individual is not an active participant in
an employer-sponsored retirement plan but the individual’s spouse is an active participant, the deduction limit
is phased out between $150,000 and $160,000 of AGI.
All taxpayers may make nondeductible contributions to
a traditional IRA, regardless of income. Account earnings from IRAs are not includible in income when

62
earned. However, distributions from traditional IRAs
are includible in income, except to the extent they are
a return of nondeductible contributions.
Under prior law, the maximum annual contribution
to an IRA was the lesser of $2,000 or the individual’s
compensation. In the case of married taxpayers filing
a joint return, annual contributions of up to $2,000
were allowed for each spouse, provided the combined
compensation of the spouses was at least equal to the
contributed amount. This Act increases the maximum
annual contribution to an IRA to $3,000 for taxable
years 2002 through 2004, $4,000 for taxable years 2005
through 2007, and $5,000 for taxable year 2008. For
taxable years 2009 and 2010, the limit is adjusted annually for inflation in $500 increments. Effective for
taxable years beginning after December 31, 2001, individuals who attain age 50 before the end of the year
may make additional catch-up contributions to an IRA.
For these individuals, the otherwise maximum contribution limit (before application of the AGI phaseout limits) is increased by $500 for taxable years 2002
through 2005 and by $1,000 for taxable years 2006
through 2010.
Increase contribution and benefit limits under
qualified pension plans.—Limits on contributions
and benefits under qualified pension plans are based
on the type of plan. Under prior law, annual additions
to a defined contribution plan with respect to each plan
participant were limited to the lesser of (1) 25 percent
of compensation or (2) $35,000 (for 2001), adjusted for
inflation in $5,000 increments. Under prior law, the
maximum annual benefit payable at an individual’s social security retirement age under a defined benefit
plan was generally the lesser of (1) 100 percent of average compensation, or (2) $140,000 (for 2001), adjusted
for inflation in $5,000 increments. The annual compensation of each participant that could be taken into
account for purposes of determining contributions and
benefits under a plan generally was limited to $170,000
(for 2001), adjusted for inflation in $10,000 increments.
Maximum annual elective deferrals that an individual
was allowed to make to a qualified cash or deferred
arrangement (401(k) plan), a tax-sheltered annuity (section 403(b) annuity), or a salary reduction simplified
employee pension plan (SEP) under prior law were limited to $10,500 (for 2001), adjusted for inflation in increments of $500. The maximum amount of annual
elective deferrals that an individual was allowed to
make to a savings incentive match plan (SIMPLE plan)
under prior law was $6,500 (for 2001), adjusted for
inflation in increments of $500. Under prior law the
maximum annual deferral under an eligible deferred
compensation plan of a State or local government or
a tax-exempt organization (a section 457 plan) was the
lesser of (1) $8,500 (for 2001), adjusted for inflation
in increments of $500, or (2) 33 1/3 percent of compensation. In the three years prior to retirement, the
limit on contributions to an eligible section 457 plan
is generally increased to twice the otherwise applicable
dollar limit.

ANALYTICAL PERSPECTIVES

Effective for taxable years beginning after December
31, 2001, the contribution limit to a defined contribution plan is increased to the lesser of 100 percent of
compensation or $40,000 (adjusted annually for inflation in $1,000 increments after 2002). Effective for taxable years ending after December 31, 2001, the benefit
limit for defined benefit plans is increased to $160,000
(adjusted annually for inflation for plans ending after
December 31, 2002, in increments of $1,000) and calculated as a benefit payable at age 62. The compensation that may be taken into account under a plan is
increased to $200,000 in 2002 (indexed annually thereafter in $5,000 increments). The dollar limit on annual
elective deferrals under section 401(k) plans, section
403(b) annuities and salary reduction SEPs is increased
to $11,000 in 2002, and increased annually thereafter
in $1,000 increments, reaching $15,000 in 2006 (adjusted annually for inflation in increments of $500 after
2006). The dollar limit on annual elective deferrals to
a SIMPLE plan is increased to $7,000 in 2002, and
increased annually thereafter in $1,000 increments,
reaching $10,000 in 2005 (adjusted for inflation in increments of $500 after 2006). The dollar limit on contributions to an eligible section 457 plan is increased
to the lesser of (1) 100 percent of includable compensation or (2) $11,000 in 2002, $12,000 in 2003, $13,000
in 2004, $14,000 in 2005, and $15,000 in 2006 (adjusted
for inflation in increments of $500 after 2006).
Permit catch-up contributions to certain salary
reduction arrangements.—Effective for taxable years
beginning after December 31, 2001, the otherwise applicable dollar limit on elective deferrals under a section
401(k) plan, section 403(b) annuity, SEP or SIMPLE
plan, or deferrals under a section 457 plan is increased
for individuals who attain age 50 by the end of the
year. The additional amount of elective contributions
that is permitted to be made by an eligible individual
participating in such a plan is the lesser of: (1) the
applicable dollar amount or (2) the participant’s compensation for the year after reduction by any other
elective deferrals of the participant for the year. The
applicable dollar amount under a 401(k) plan, section
403(b) plan, SEP, or section 457 plan is $1,000 for
2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005,
and $5,000 for 2006 through 2010 (adjusted annually
for inflation in $500 increments beginning in 2007).
The applicable dollar amount under a SIMPLE plan
is $500 for 2002, $1,000 for 2003, $1,500 for 2004,
$2,000 for 2005, and $2,500 for 2006 through 2010 (adjusted annually for inflation in $500 increments beginning in 2007).
Provide a nonrefundable tax credit to certain
individuals for elective deferrals and IRA contributions.—For taxable years beginning after December 31, 2001 and before January 1, 2007, a nonrefundable tax credit is provided for up to $2,000 in contributions made by eligible taxpayers to a qualified plan
or to a traditional or Roth IRA. The credit, which is
in addition to any deduction or exclusion that would

4.

63

FEDERAL RECEIPTS

otherwise apply with respect to the contribution, is
available to single taxpayers with AGI less than or
equal to $25,000 ($37,500 for heads of household and
$50,000 for married taxpayers filing a joint return).
The credit is available to individuals who are 18 years
of age or older (other than individuals who are fulltime students or claimed as a dependent on another
taxpayer’s return) and is offset against both the regular
and alternative minimum tax. The credit rate is 50
percent for single taxpayers with AGI less than or equal
to $15,000 ($30,000 for married taxpayers filing a joint
return and $22,500 for heads of household), 20 percent
for single taxpayers with AGI between $15,000 and
$16,250 (between $30,000 and $32,500 for married taxpayers filing a joint return and between $22,500 and
$24,375 for heads of household), and 10 percent for
single taxpayers with AGI between $16,250 and
$25,000 (between $32,500 and $50,000 for married taxpayers filing a joint return and between $24,375 and
$37,500 for heads of household).
Provide tax credit for new retirement plan expenses of small businesses.—Effective for taxable
years beginning after December 31, 2001, a nonrefundable tax credit is provided for qualified administrative
and retirement-education expenses incurred by a small
business (an employer that did not employ, in the preceding year, more than 100 employees with compensation in excess of $5,000) that adopts a new qualified
defined benefit or defined contribution plan (including
a section 401(k) plan), SIMPLE plan, or SEP. The credit
applies to 50 percent of the first $1,000 in qualifying
expenses for the plan for each of the first three years
of the plan. The 50 percent of qualifying expenses offset
by the credit are not deductible; the other 50 percent
of qualifying expenses (and other expenses) are deductible as under prior law.
Modify other pension and retirement provisions.—In addition to the provisions described above,
this Act expands coverage in pension and retirement
plans through provisions that: (1) require accelerated
vesting for matching employer contributions, (2) modify
the definition of key employee, (3) eliminate IRS user
fees for certain determination letter requests regarding
employer plans, (4) modify the application of the deduction limitation with regard to elective deferral contributions, (5) repeal the rules coordinating contributions
to eligible section 457 plans with contributions under
other types of plans, (6) increase the annual limitation
on the amount of deductible contributions made by an
employer to a profit-sharing or stock bonus plan, (7)
modify the definition of compensation for purposes of
the deduction rules, (8) provide the option to treat elective deferrals as after-tax contributions, (9) improve notice to employees for pension amendments reducing future accruals, (10) increase portability, (11) strengthen
pension security and enforcement, and (12) reduce regulatory burdens.

Other Provisions
Provide minimum tax relief to individuals.—An
alternative minimum tax is imposed on individuals to
the extent that the tentative minimum tax exceeds the
regular tax. An individual’s tentative minimum tax generally is equal to the sum of: (1) 26 percent of the
first $175,000 ($87,500 in the case of a married individual filing a separate return) of alternative minimum
taxable income (taxable income modified to take account of specified preferences and adjustments) in excess of an exemption amount and (2) 28 percent of
the remaining alternative minimum taxable income.
The AMT exemption amounts under prior law were:
(1) $45,000 for married taxpayers filing a joint return
and surviving spouses; (2) $33,750 for single taxpayers,
and (3) $22,500 for married taxpayers filing a separate
return, estates and trusts. The exemption amounts are
phased out by an amount equal to 25 percent of the
amount by which the individual’s alternative minimum
taxable income exceeds: (1) $150,000 for married taxpayers filing a joint return and surviving spouses, (2)
$112,500 for single taxpayers, and (3) $75,000 for married taxpayers filing a separate return, estates and
trusts. The exemption amounts, the threshold phaseout amounts, and the rate brackets are not indexed
for inflation. Effective for taxable years beginning after
December 31, 2001 and before January 1, 2005, the
exemption amount is increased to $49,000 for married
taxpayers filing a joint return and surviving spouses,
$35,750 for single taxpayers, and $24,500 for married
taxpayers filing a separate return, estates and trusts.
Modify the timing of estimated tax payments by
corporations.—Corporations generally are required to
pay their income tax liability in quarterly estimated
payments. For corporations that keep their accounts
on a calendar year basis, these payments are due on
or before April 15, June 15, September 15 and December 15 (if these dates fall on a holiday or weekend,
payment is due on the next business day). This Act
allowed corporations to delay the estimated payment
otherwise due on September 17, 2001 until October 1,
2001; 20 percent of the estimated tax payment otherwise due on September 15, 2004 may be delayed until
October 1, 2004.
VICTIMS OF TERRORISM TAX RELIEF ACT OF
2001
This Act provides income and estate tax relief to the
survivors of victims of (1) the September 11, 2001 terrorist attacks on the United States, (2) the April 19,
1995 Oklahoma City bombing, and (3) exposure to anthrax on or after September 11, 2001 and before January 1, 2002. General relief is also provided for victims
of disasters and terrorist actions. The tax relief provided in this Act does not apply to any individual identified by the Attorney General to have been a participant or conspirator in the terrorist attack or attacks
to which a specific provision applies, or a representative

64
of such individual. The major provisions of this Act
are described below.
Provide individual income tax relief to victims
of terrorist attacks.—Under current law an individual
in active service as a member of the Armed Forces
who dies while serving in a combat zone is not subject
to income tax for the year of death (as well as for
any prior taxable year ending on or after the first day
the individual served in the combat zone). In addition,
military and civilian employees of the United States
are exempt from income taxes if they die as a result
of wounds or injury incurred outside the United States
in terrorist or military action. This exemption is available for the year of death and for prior taxable years
beginning with the taxable year prior to the taxable
year in which the wounds or injury were incurred. This
Act extends relief similar to the present-law treatment
of military or civilian employees of the United States
who die as a result of terrorist or military activity
outside the United States to individuals who die from
wounds or injury incurred as a result of: (1) the terrorist attacks on September 11, 2001 or April 19, 1995,
or (2) exposure to anthrax on or after September 11,
2001 and before January 1, 2002. These individuals
(whether killed as a result of an attack or in rescue
or recovery operations) generally are exempt from income tax for the year of death and for prior taxable
years beginning with the taxable year prior to the taxable year in which the wounds or injury occurred. A
minimum tax relief benefit of $10,000 will be provided
to each eligible individual regardless of the income tax
liability incurred during the eligible tax years.
Exclude certain death benefits from gross income.—In general, gross income includes income from
whatever source derived, including payments made as
a result of the death of an individual. Under this Act,
amounts paid by an employer by reason of the death
of an employee attributable to wounds or injury incurred as a result of the terrorist attacks on September
11, 2001 or April 19, 1995, or exposure to anthrax
on or after September 11, 2001 and before January
1, 2002, are excluded from gross income. Subject to
rules prescribed by the Secretary of the Treasury, the
exclusion does not apply to amounts that would have
been payable if the individual had died for a reason
other than the specified attacks.
Provide a reduction in Federal estate taxes.—
Under current law a reduction in Federal estate taxes
is provided for taxable estates of U.S. citizens or residents who are active members of the U.S. Armed Forces
and who are killed in action while serving in a combat
zone. This estate tax reduction also applies to active
service members who die as a result of wounds, disease,
or injury suffered while serving in a combat zone by
reason of a hazard to which the service member was
subjected as an incident of such service. This Act simplifies the estate tax relief provided for combat-related
deaths and generally treats individuals who die from

ANALYTICAL PERSPECTIVES

wounds or injury incurred as a result of the terrorist
attacks that occurred on September 11, 2001 and April
19, 1995, or as a result of exposure to anthrax on or
after September 11, 2001 and before January 1, 2002,
in the same manner as if they were active members
of the U.S. Armed Forces killed in action while serving
in a combat zone or dying as a result of wounds or
injury suffered while serving in a combat zone. The
executor of an estate eligible for the reduction may
elect not to have the reduction apply if more favorable
tax treatment would be available under generally applicable rules. The reduction effectively shields the first
$8.8 million of a victim’s estate from Federal estate
taxes and reduces estate tax rates.
Treat payments by charitable organizations as
exempt payments.—Under current law, charitable organizations generally are exempt from taxation. Such
organizations must be organized and operated exclusively for exempt purposes and no part of the net earnings of such organizations may inure to the benefit
of any private shareholder or individual. Such organizations must serve a public rather than a private interest
and generally must serve a charitable class of persons
that is indefinite or of sufficient size. Under this Act,
charitable organizations that make payments on or
after September 11, 2001 by reason of the death, injury,
wounding, or illness of an individual incurred as a result of the September 11, 2001 attacks, or as a result
of exposure to anthrax occurring on or after September
11, 2001 and before January 1, 2002, are not required
to make a specific assessment of need for the payments
to be related to the purpose or function constituting
the basis for the organization’s exemption. This rule
applies provided that the organization makes the payments in good faith using a reasonable and objective
formula that is consistently applied. Such payments
must be for public and not private benefit and must
serve a charitable class. Similarly, if a tax-exempt private foundation makes payments under the conditions
described above, the payment will not be subject to
excise taxes on self-dealing, even if made to a person
who is otherwise disqualified under current law.
Provide exclusion for certain cancellations of indebtedness.—Gross income generally includes income
that is realized by a debtor from the discharge of indebtedness, subject to certain exceptions for debtors in
Title 11 bankruptcy cases, insolvent debtors, certain
farm indebtedness, and certain real property business
indebtedness. Under this Act, an exclusion from gross
income is provided for any amount realized from the
discharge (in whole or in part) of indebtedness if the
indebtedness is discharged by reason of the death of
an individual incurred as a result of the September
11, 2001 terrorist attacks, or as a result of anthrax
exposure occurring on or after September 11, 2001 and
before January 1, 2002. This exclusion applies to discharges made on or after September 11, 2001 and before January 1, 2002.

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65

FEDERAL RECEIPTS

Provide general tax relief for victims of terrorist/
military actions, Presidentially-declared disasters,
and certain other disasters.—This Act also: (1) clarifies that payments of compensation made under the
Air Transportation Safety and System Stabilization Act
are excludable from gross income, (2) provides a specific
exclusion from gross income for ‘‘qualified disaster relief
payments,’’ (3) expands the authority of the Secretary
of the Treasury to prescribe regulations concerning
deadlines for performing various acts under the Internal Revenue Code and the waiver of interest on underpayments of tax liability, (4) expands the present-law
exclusion from gross income for disability income of
U.S. civilian employees attributable to a terrorist attack
outside the United States to apply to disability income
received by any individual attributable to a terrorist
or military action, (5) extends the income tax relief
provided under current law to U.S. military and civilian
personnel who die as a result of terrorist or military
activity outside the United States to such personnel
regardless of where the terrorist or military action occurs, (6) modifies the tax treatment of structured settlement arrangements, (7) modifies the personal exemption deduction for certain disability trusts, and (8) expands the availability of returns and return information
for purposes of investigating terrorist incidents, threats,
or activities, and for analyzing intelligence concerning
terrorist incidents, threats, or activities.
RAILROAD RETIREMENT AND SURVIVORS’
IMPROVEMENT ACT OF 2001
The Federally administered railroad retirement system is a two-tier system consisting of social security
equivalent benefits (frequently referred to as Tier I benefits) and a rail industry pension plan (frequently referred to as Tier II benefits). This Act modernizes the
financing of the railroad retirement system and provides enhanced benefits to retirees and survivors.
Under prior law, the Tier II payroll tax levied on the
annual taxable wage base of rail industry employees
was 16.1 percent for employers and 4.9 percent for employees. This Act reduces the rate for employers to 15.6
percent in 2002 and to 14.2 percent in 2003. Starting
in 2004, the rates are adjusted annually and linked
to the level of Tier II reserves. Under current estimates,
those rates are expected to be 13.1 percent for employers and 4.9 percent for employees; the rates necessary
to maintain reserves at a level sufficient to fund benefits for four years. If the reserve fund falls below the
level sufficient to fund four years of benefits or increases to a level sufficient to fund more than six years

of benefits, then payroll tax rates would change according to a schedule set in the Act. The rate on employers
can vary between 8.2 percent and 22.1 percent, while
the rate on employees can vary between zero and 4.9
percent.
INVESTOR AND CAPITAL MARKETS FEE
RELIEF ACT
The Securities and Exchange Commission (SEC) collects fees for registrations, mergers, and transactions
of securities. Under prior law, some of these fees were
classified as receipts and others were classified as offsetting collections (outlays). The specific fees collected
included the following: (1) Transaction fees equal to
1/300th of a percent (1/800th of a percent beginning
in 2008) of the aggregate dollars traded through national securities exchanges, national securities associations, brokers, and dealers. (2) Registration fees equal
to $200 per $1 million ($67 per $1 million beginning
in 2007) of the maximum aggregate price for securities
that are proposed to be offered. Additional registration
fees (subject to appropriation) equal to $39 per $1 million for 2002 ($28 for 2003, $9 for 2004, $5 for 2005
and zero for 2006 and subsequent years) of the aggregate price for securities proposed to be offered. (3)
Merger fees equal to $200 per $1 million of the value
of securities proposed to be purchased as part of a
merger. (4) Assessments on transactions of single stock
futures equal to $.02 per transaction ($.0075 per transaction beginning in 2007).
This Act reclassifies all of these fees as offsetting
collections (outlays) and adjusts the fee rates as follows:
(1) Transaction fees are reduced to $15 per $1 million
of the aggregate dollars traded. For 2003 and each subsequent year, the SEC is required to establish a rate
that would generate transaction fee collections equal
to a target amount for that year. (2) Registration fees
are reduced to $92 per $1 million of the maximum
aggregate price for securities that are proposed to be
offered. For 2003 and each subsequent year, the SEC
is required to establish a fee rate that would generate
collections equal to a target amount. (3) Merger fees
are reduced to $92 per $1 million of the value of securities proposed to be purchased as part of a merger.
For 2003 and each subsequent year, these fees would
be equal to the rate for registration fees. (4) Assessments on transactions of single stock futures would
be reduced to $0.009 per transaction for 2002 through
2006 and then fall to $0.0042 per transaction for 2007
and subsequent years.

ADMINISTRATION PROPOSALS
The President’s plan provides tax incentives for charitable giving, education, the disabled, health care, farmers, and the environment. It also provides tax incentives designed to increase domestic production of oil
and gas and promote energy conservation, extends for
two years provisions that expired in 2001, permanently

extends the research and experimentation (R&E) tax
credit, and permanently extends the provisions of the
Economic Growth and Tax Relief Reconciliation Act of
2001 that sunset on December 31, 2010. In addition,
the President intends to work with the Congress in
a bipartisan manner to enact an economic security plan

66

ANALYTICAL PERSPECTIVES

that will provide an immediate and effective stimulus
to the Nation’s economy. In addition, the Treasury Department will be conducting a thorough review of
means of simplifying the tax code. The Administration
intends to work with Congress, tax practitioners, tax
administrators, and taxpayers to produce meaningful
simplification. An introduction to these efforts is contained at the end of this Chapter.
BIPARTISAN ECONOMIC SECURITY PLAN
The President believes that it is crucial for Congress
to quickly pass an economic security bill that will reinvigorate economic growth and assist workers affected
by the economic downturn that has followed the terrorist attacks of September 11, 2001. To prevent further
job losses and help displaced workers get back to work
quickly, the Administration will continue to work with
Congress in a bipartisan manner to enact an economic
stimulus package and a worker assistance package to
provide additional temporary, quick, and effective help
for those who have lost their jobs
TAX INCENTIVES
Provide Incentives for Charitable Giving
Provide charitable contribution deduction for
nonitemizers.—Under current law, individual taxpayers who do not itemize their deductions (nonitemizers) are not able to deduct contributions to qualified charitable organizations. The Administration proposes to allow nonitemizers to deduct charitable contributions in addition to claiming the standard deduction, effective for taxable years beginning after December 31, 2001. The deduction would be phased in between 2002 and 2012, as follows: (1) Single taxpayers
would be allowed a maximum deduction of $100 in 2002
through 2004, $300 in 2005 through 2011, and $500
in 2012 and subsequent years. (2) Married taxpayers
filing a joint return would be allowed a maximum deduction of $200 in 2002 through 2004, $600 in 2005
through 2011, and $1,000 in 2012 and subsequent
years. Deductible contributions would be subject to existing rules governing itemized charitable contributions,
such as the substantiation requirements and the percentage-of-AGI limitations.
Permit tax-free withdrawals from IRAs for charitable contributions.—Under current law, eligible individuals may make deductible or non-deductible contributions to a traditional IRA. Pre-tax contributions
and earnings in a traditional IRA are included in income when withdrawn. Effective for distributions after
December 31, 2001, the Administration proposes to
allow individuals who have attained age 591⁄2 to exclude
from gross income IRA distributions made directly to
a charitable organization. The exclusion would apply
without regard to the percentage-of-AGI limitations
that apply to deductible charitable contributions. The
exclusion would apply only to the extent the individual
receives no return benefit in exchange for the transfer,

and no charitable deduction would be allowed with respect to any amount that is excludable from income
under this provision.
Raise the cap on corporate charitable contributions.—Current law limits deductible charitable contributions by corporations to 10 percent of net income
(calculated before the deduction of the charitable contributions and certain other deductions). The Administration proposes to increase the limit on deductible
charitable contributions by corporations from 10 percent
to 15 percent of net income, effective for taxable years
beginning after December 31, 2001.
Expand and increase the enhanced charitable
deduction for contributions of food inventory.—A
taxpayer’s deduction for charitable contributions of inventory generally is limited to the taxpayer’s basis
(typically cost) in the inventory. However, for certain
contributions of inventory, C corporations may claim
an enhanced deduction equal to the lesser of: (1) basis
plus one half of the fair market value in excess of
basis, or (2) two times basis. To be eligible for the
enhanced deduction, the contributed property generally
must be inventory of the taxpayer, contributed to a
charitable organization, and the donee must (1) use
the property consistent with the donee’s exempt purpose solely for the care of the ill, the needy, or infants,
(2) not transfer the property in exchange for money,
other property, or services, and (3) provide the taxpayer
a written statement that the donee’s use of the property
will be consistent with such requirements. To use the
enhanced deduction, the taxpayer must establish that
the fair market value of the donated item exceeds basis.
Under the Administration’s proposal, which is designed to encourage contributions of food inventory to
charitable organizations, any taxpayer engaged in a
trade or business would be eligible to claim an enhanced deduction for donations of food inventory. The
enhanced deduction for donations of food inventory
would be increased to the lesser of: (1) fair market
value, or (2) two times basis. However, to ensure consistent treatment of all businesses claiming an enhanced deduction for donations of food inventory, the
enhanced deduction for qualified food donations by S
corporations and non-corporate taxpayers would be limited to 15 percent of net income from the trade or
business. A special provision would allow taxpayers
with a zero or low basis in the qualified food donation
(e.g., taxpayers that use the cash method of accounting
for purchases and sales, and taxpayers that are not
required to capitalize indirect costs) to assume a basis
equal to 25 percent of fair market value. The enhanced
deduction would be available only for donations of ‘‘apparently wholesome food’’ (food intended for human consumption that meets all quality and labeling standards
imposed by Federal, State, and local laws and regulations, even though the food may not be readily marketable due to appearance, age, freshness, grade, size, surplus, or other conditions). The fair market value of ‘‘apparently wholesome food’’ that cannot or will not be

4.

FEDERAL RECEIPTS

sold solely due to internal standards of the taxpayer
or lack of market, would be determined by taking into
account the price at which the same or substantially
the same food items are sold by the taxpayer at the
time of the contribution or, if not sold at such time,
in the recent past. These proposed changes in the enhanced deduction for donations of food inventory would
be effective for taxable years beginning after December
31, 2001.
Reform excise tax based on investment income
of private foundations.—Under current law, private
foundations that are exempt from Federal income tax
are subject to a two-percent excise tax on their net
investment income (one-percent if certain requirements
are met). The tax on private foundations that are not
exempt from Federal income tax, such as certain charitable trusts, is equal to the excess of the sum of the
excise tax that would have been imposed if the foundation were tax exempt and the amount of the unrelated
business income tax that would have been imposed if
the foundation were tax exempt, over the income tax
imposed on the foundation. To encourage increased
charitable activity and simplify the tax laws, the Administration proposes to replace the two rates of tax
on the net investment income of private foundations
that are exempt from Federal income tax with a single
tax rate of one percent. The tax on private foundations
not exempt from Federal income tax would be equal
to the excess of the sum of the one-percent excise tax
that would have been imposed if the foundation were
tax exempt and the amount of the unrelated business
income tax what would have been imposed if the foundation were tax exempt, over the income tax imposed
on the foundation. The proposed change would be effective for taxable years beginning after December 31,
2001.
Modify tax on unrelated business taxable income
of charitable remainder trusts.—A charitable remainder annuity trust is a trust that is required to
pay, at least annually, a fixed dollar amount of at least
five percent of the initial value of the trust to a noncharity for the life of an individual or for a period
of 20 years or less, with the remainder passing to charity. A charitable remainder unitrust is a trust that
generally is required to pay, at least annually, a fixed
percentage of at least five percent of the fair market
value of the trust’s assets determined at least annually
to a non-charity for the life of an individual or for
a period of 20 years or less, with the remainder passing
to charity. A trust does not qualify as a charitable
remainder annuity if the annuity for a year is greater
than 50 percent of the initial fair market value of the
trust’s assets. A trust does not qualify as a charitable
remainder unitrust if the percentage of assets that are
required to be distributed at least annually is greater
than 50 percent. A trust does not qualify as a charitable
remainder annuity trust or a charitable remainder
unitrust unless the value of the remainder interest in
the trust is at least 10 percent of the value of the

67
assets contributed to the trust. Distributions from a
charitable remainder annuity trust or charitable remainder unitrust, which are included in the income
of the beneficiary for the year that the amount is required to be distributed, are treated in the following
order as: (1) ordinary income to the extent of the trust’s
current and previously undistributed ordinary income
for the trust’s year in which the distribution occurred,
(2) capital gains to the extent of the trust’s current
capital gain and previously undistributed capital gain
for the trust’s year in which the distribution occurred,
(3) other income to the extent of the trust’s current
and previously undistributed other income for the
trust’s year in which the distribution occurred, and (4)
corpus (trust principal).
Charitable remainder annuity trusts and charitable
remainder unitrusts are exempt from Federal income
tax; however, such trusts lose their income tax exemption for any year in which they have unrelated business
taxable income. Any taxes imposed on the trust are
required to be allocated to trust corpus. The Administration proposes to levy a 100-percent excise tax on
the unrelated business taxable income of charitable remainder trusts, in lieu of removing the Federal income
tax exemption for any year in which unrelated business
taxable income is incurred. This change, which is a
more appropriate remedy than loss of tax exemption,
is proposed to become effective for taxable years beginning after December 31, 2001, regardless of when the
trust was created.
Modify basis adjustment to stock of S corporations contributing appreciated property.—Under
current law, each shareholder in an S corporation separately accounts for his/her pro rata share of the S corporation’s charitable contributions in determining his/
her income tax liability. A shareholder’s basis in the
stock of the S corporation must be reduced by the
amount of his/her pro-rata share of the S corporation’s
charitable contribution. In order to preserve the benefit
of providing a charitable contribution deduction for contributions of appreciated property and to prevent the
recognition of gain on the contributed property on the
disposition of the S corporation stock, the Administration proposes to allow a shareholder in an S corporation
to increase his/her basis in the stock of an S corporation
by an amount equal to the excess of the shareholder’s
pro rata share of the S corporation’s charitable contribution over the stockholder’s pro rata share of the
adjusted basis of the contributed property. The proposal
would be effective for taxable years beginning after December 31, 2001.
Allow expedited consideration of applications
for exempt status.—The Administration proposes to
allow expedited consideration of applications for exempt
status by organizations formed for the primary purpose
of providing social services to the poor and the needy.
To be eligible, the organization must have applied for
a grant under a Federal, State, or local program that
provides funding for social service programs on or be-

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ANALYTICAL PERSPECTIVES

fore the day that the organization applies to the Secretary of the Treasury for determination of its exempt
status. Organizations that demonstrate that under the
terms of the grant program exempt status is required
before the organization is eligible to apply for a grant
would also qualify for expedited consideration. Each organization would be required to include with its application for exempt status a copy of its completed grant
application. The proposal would be effective for taxable
years beginning after December 31, 2001.
Strengthen and Reform Education
Provide refundable tax credit for certain costs
of attending a different school for pupils assigned
to failing public schools.—Under the Administration’s proposal, a refundable tax credit would be allowed for 50 percent of the first $5,000 of qualifying
elementary and secondary education expenses incurred
during the taxable year with respect to enrollment of
a qualifying student in a qualifying school. Qualifying
students would be those who, for a given school year,
would normally attend a public school determined by
the State as not having made ‘‘adequate yearly
progress’’ under the terms of the Elementary and Secondary Education Act as amended by the No Child
Left Behind Act of 2001. A qualifying student in one
school year generally would qualify for an additional
school year even if the school normally attended made
adequate yearly progress by the beginning of the second
school year. A qualifying school would be any public
school making adequate yearly progress or private elementary or secondary school. Qualifying expenses generally would be tuition, required fees, and transportation costs incurred by the taxpayer in connection with
the attendance at a qualifying school. The proposal
would be effective with respect to expenses incurred
beginning with the 2002–2003 school year through the
2006–2007 school year.
Allow teachers to deduct out-of-pocket classroom
expenses.—Under current law, teachers who incur unreimbursed, job-related expenses may deduct those expenses to the extent that when combined with other
miscellaneous itemized deductions they exceed 2 percent of AGI, but only if the teacher itemizes deductions
(i.e., does not use the standard deduction). Effective
for expenses incurred in taxable years beginning after
December 31, 2003, the Administration proposes to
allow certain teachers and other elementary and secondary school professionals to treat up to $400 in qualified out-of-pocket classroom expenses as a non-itemized
deduction (above-the-line deduction). Unreimbursed expenditures for certain books, supplies and equipment
related to classroom instruction and for certain professional training programs would qualify for the deduction.

Invest in Health Care
Provide refundable tax credit for the purchase
of health insurance.—Current law provides a tax
preference for employer-provided group health insurance plans, but not for individually purchased health
insurance coverage except to the extent that deductible
medical expenses exceed 7.5 percent of AGI or the individual has self-employment income. The Administration
proposes to make health insurance more affordable for
individuals not covered by an employer plan or a public
program. Effective for taxable years beginning after December 31, 2002, a new refundable tax credit would
be provided for the cost of health insurance purchased
by individuals under age 65. The credit would provide
a subsidy for a percentage of the health insurance premium, up to a maximum includable premium. The maximum subsidy percentage would be 90 percent for lowincome taxpayers and would phase down with income.
The maximum credit would be $1,000 for an adult and
$500 for a child. The credit would be phased out at
$30,000 for single taxpayers and $60,000 for families
purchasing a family policy.
Individuals could claim the tax credit for health insurance premiums paid as part of the normal tax-filing
process. Alternatively, beginning July 1, 2003, the tax
credit would be available in advance at the time the
individual purchases health insurance. The advance
credit would reduce the premium paid by the individual
to the health insurer, and the health insurer would
be reimbursed directly by the Department of Treasury
for the amount of the advance credit. Eligibility for
an advance credit would be based on an individual’s
prior year tax return. To qualify for the credit, a health
insurance policy would have to include coverage for catastrophic medical expenses. Qualifying insurance could
be purchased in the individual market. Qualifying
health insurance could also be purchased through private purchasing groups, State-sponsored insurance purchasing pools, and high-risk pools. Such groups may
help reduce health insurance costs and increase coverage options for individuals, including older and higher-risk individuals. Individuals would not be allowed
to claim the credit and make a contribution to an Archer Medical Savings Account (MSA) for the same taxable year.
Provide an above-the-line deduction for longterm care insurance premiums.—Current law provides a tax preference for employer-paid long-term care
insurance. However, the vast majority of the long-term
care insurance market consists of individually purchased policies, for which no tax preference is provided
except to the extent that deductible medical expenses
exceed 7.5 percent of AGI or the individual has selfemployment income. Premiums on qualified long-term
care insurance are deductible as a medical expense,
subject to annual dollar limitations that increase with
age. The Administration proposes to make individually-

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FEDERAL RECEIPTS

purchased long-term care insurance (the vast majority
of the long-term care insurance market) more affordable
by creating an above-the-line deduction for qualified
long-term care insurance premiums. To qualify for the
deduction, the long-term care insurance would be required to meet certain standards providing consumer
protections. The deduction would be available to taxpayers who individually purchase qualified long-term
care insurance and to those who pay at least 50 percent
of the cost of employer-provided coverage. The deduction would be effective for taxable years beginning after
December 31, 2003 but would be phased in over five
years. The deduction would be subject to current law
annual dollar limitations on qualified long-term care
insurance premiums.
Allow up to $500 in unused benefits in a health
flexible spending arrangement to be carried forward to the next year.—Under current law, unused
benefits in a health flexible spending arrangement
under a cafeteria plan for a particular year revert to
the employer at the end of the year. Effective for plan
years beginning after December 31, 2003, the Administration proposes to allow up to $500 in unused benefits
in a health flexible spending arrangement at the end
of a particular year to be carried forward to the next
plan year.
Provide additional choice with regard to unused
benefits in a health flexible spending arrangement.—In addition to the proposed carryforward of unused benefits (see preceding discussion), the Administration proposes to allow up to $500 in unused benefits
in a health flexible spending arrangement at the end
of a particular year to be distributed to the participant
as taxable income, contributed to an Archer MSA, or
contributed to the employer’s 401(k), 403(b), or governmental 457(b) retirement plan. Amounts distributed to
the participant would be subject to income tax withholding and employment taxes. Amounts contributed
to an Archer MSA or retirement plan would be subject
to the normal rules applicable to elective contributions
to the receiving plan or account. The proposal would
be effective for plan years beginning after December
31, 2003.
Permanently extend and reform Archer Medical
Savings Accounts.—Current law allows only self-employed individuals and employees of small firms to establish Archer MSAs, and caps the number of accounts
at 750,000. In addition to other requirements, (1) individuals who establish MSAs must be covered by a highdeductible health plan (and no other plan) with a deductible of at least $1,650 but not greater than $2,500
for policies covering a single person and a deductible
of at least $3,300 but not greater than $4,950 in all
other cases, (2) tax-preferred contributions are limited
to 65 percent of the deductible for single policies and
75 percent of the deductible for other policies, and (3)
either an individual or an employer, but not both, may
make a tax-preferred contribution to an MSA for a par-

69
ticular year. The Administration proposes to permanently extend the MSA program, which is scheduled
to expire on December 31, 2002, and to modify the
program to make it more consistent with currently
available health plans. Effective after December 31,
2002, the Administration proposes to remove the
750,000 cap on the number of accounts. In addition,
the program would be reformed by (1) expanding eligibility to include all individuals and employees of firms
of all sizes covered by a high-deductible health plan,
(2) modifying the definition of high deductible to permit
a deductible as low as $1,000 for policies covering a
single person and $2,000 in all other cases, (3) increasing allowable tax-preferred contributions to 100 percent
of the deductible, (4) allowing tax-preferred contributions by both employers and employees for a particular
year, up to the applicable maximum, (5) allowing contributions to MSAs under cafeteria plans, and (6) permitting qualified plans to provide, without counting
against the deductible, up to $100 of coverage for allowable preventive services per covered individual each
year. Individuals would not be allowed to make a contribution to an MSA and claim the proposed refundable
tax credit for health insurance premiums for the same
taxable year.
Provide an additional personal exemption to
home caretakers of family members.—Current law
provides a tax deduction for certain long-term care expenses. In addition, taxpayers are allowed to claim exemptions for themselves (and their spouses, if married)
and dependents who they support. However, neither
provision may meet the needs of taxpayers who provide
long-term care in their own home for close family members. Effective for taxable years beginning after December 31, 2003, the Administration proposes to provide
an additional personal exemption to taxpayers who care
for certain qualified family members who reside with
the taxpayer in the household maintained by the taxpayer. A taxpayer is considered to maintain a household only if he/she furnishes over half of the annual
cost of maintaining the household. Qualified family
members would include any individual with long-term
care needs who (1) is the spouse of the taxpayer or
an ancestor of the taxpayer or the spouse of such an
ancestor and (2) is a member of the taxpayer’s household for the entire year. An individual would be considered to have long-term care needs if he or she were
certified by a licensed physician (prior to the filing of
a return claiming the exemption) as being unable for
at least 180 consecutive days to perform at least two
activities of daily living without substantial assistance
from another individual due to a loss of functional capacity. Alternatively, an individual would be considered
to have long-term care needs if he or she were certified
by a licensed physician as, for at least 180 consecutive
days, (1) requiring substantial supervision to be protected from threats to his or her own health and safety
due to severe cognitive impairment and (2) being unable to perform at least one activity of daily living
or being unable to engage in age appropriate activities.

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ANALYTICAL PERSPECTIVES

Assist Americans With Disabilities
Exclude from income the value of employer-provided computers, software and peripherals.—The
Administration proposes to allow individuals with disabilities to exclude from income the value of employerprovided computers, software or other office equipment
that are necessary for the individual to perform work
for the employer at home. To qualify for the exclusion,
the employee would be required to make substantial
use of the equipment (relative to overall use) performing work for his or her employer. However, unlike
current law, which limits the exclusion to the extent
that the equipment is used to perform work for the
employer, the proposed exclusion would apply to all
use of such equipment, including use by the employee
for personal or non-employer-related trade or business
purposes. Employees would be required to provide their
employer with a certification from a licensed physician
that they meet eligibility criteria. The proposal would
be effective for taxable years beginning after December
31, 2003.
Help Farmers and Fishermen Manage Economic
Downturns
Establish Farm, Fish and Ranch Risk Management (FFARRM) savings accounts.—Current law
does not provide for the elective deferral of farm or
fishing income. However, farmers can elect to average
their farming income over a three-year period, and
farmers may carry back net operating losses over the
five previous years. In addition, taxes can be deferred
on certain forms of income, including disaster payments, crop insurance and proceeds from emergency
livestock sales. The Administration proposes to allow
up to 20 percent of taxable income attributable to an
eligible farming or fishing business to be contributed
to a FFARRM savings account each year and deducted
from income. Earnings on contributions would be taxable as earned and distributions from the account (except those attributable to earnings on contributions)
would be included in gross income. Any amount not
distributed within five years of deposit would be
deemed to have been distributed and included in gross
income; in addition, such distributions would be subject
to a 10-percent surtax. The proposal would be effective
for taxable years beginning after December 31, 2003.
Increase Housing Opportunities
Provide tax credit for developers of affordable
single-family housing.—The Administration proposes
to provide annual tax credit authority to States (including U.S. possessions) designed to promote the development of affordable single-family housing in low-income
urban and rural neighborhoods. Beginning in calendar
year 2003, first-year credit authority of $1.75 per capita
(indexed annually for inflation thereafter) would be
made available to each State. State housing agencies
would award first-year credits to single-family housing

units comprising a project located in a census tract
with median income equal to 80 percent or less of area
median income. Units in condominiums and cooperatives could qualify as single-family housing. Credits
would be awarded as a fixed amount for individual
units comprising a project. The present value of the
credits, determined on the date of a qualifying sale,
could not exceed 50 percent of the cost of constructing
a new home or rehabilitating an existing property. The
taxpayer (developer or investor partnership) owning the
housing unit immediately prior to the sale to a qualified
buyer would be eligible to claim credits over a 5-year
period beginning on the date of sale. Eligible homebuyers would be required to have incomes equal to
80 percent or less of area median income. Technical
features of the provision would follow similar features
of current law with respect to the low-income housing
tax credit and mortgage revenue bonds.
Encourage Saving
Establish Individual Development Accounts
(IDAs).—The Administration proposes to allow eligible
individuals to make contributions to a new savings vehicle, the Individual Development Account, which would
be set up and administered by qualified financial institutions, nonprofit organizations, or Indian tribes (qualified entities). Citizens or legal residents of the United
States between the ages of 18 and 60 who cannot be
claimed as a dependent on another taxpayer’s return,
are not students, and who meet certain income limitations would be eligible to establish and contribute to
an IDA. A single taxpayer would be eligible to establish
and contribute to an IDA if his/her modified AGI in
the preceding taxable year did not exceed $20,000
($30,000 for heads of household, and $40,000 for married taxpayers filing a joint return). These thresholds
would be indexed annually for inflation beginning in
2004. Qualified entities that set up and administer
IDAs would be required to match, dollar-for-dollar, the
first $500 contributed by an eligible individual to an
IDA in a taxable year. Qualified entities would be allowed a 100 percent tax credit for up to $500 in annual
matching contributions to each IDA, and a $50 tax
credit for each IDA maintained at the end of a taxable
year with a balance of not less that $100 (excluding
the taxable year in which the account was established).
Matching contributions and the earnings on those contributions would be deposited in a separate ‘‘parallel
account.’’ Contributions to an IDA by an eligible individual would not be deductible, and earnings on those
contributions would be included in income. Matching
contributions by qualified entities and the earnings on
those contributions would be tax-free. Withdrawals
from the parallel account may be made only for qualified purposes (higher education, the first-time purchase
of a home, business start-up, and qualified rollovers).
Withdrawals from the IDA for other than qualified purposes may result in the forfeiture of some or all matching contributions and the earnings on those contributions. The proposal would be effective for contributions

4.

FEDERAL RECEIPTS

made after December 31, 2002 and before January 1,
2010, to the first 900,000 IDA accounts opened before
January 1, 2008.
Protect the Environment
Permanently extend expensing of brownfields remediation costs.—Taxpayers may elect to treat certain
environmental remediation expenditures that would
otherwise be chargeable to capital account as deductible
in the year paid or incurred. Under current law, the
ability to deduct such expenditures expires with respect
to expenditures paid or incurred after December 31,
2003. The Administration proposes to permanently extend this provision, facilitating its use by businesses
to undertake projects that may extend beyond the current expiration date and be uncertain in overall duration.
Exclude 50 percent of gains from the sale of
property for conservation purposes.—The Administration proposes to create a new incentive for private,
voluntary land protection. This incentive is a cost-effective, non-regulatory approach to conservation. Under
the proposal, when land (or an interest in land or
water) is sold for conservation purposes, only 50 percent
of any gain would be included in the seller’s income.
To be eligible for the exclusion, the sale may be either
to a government agency or to a qualified conservation
organization, and the buyer must supply a letter of
intent that the acquisition will serve conservation purposes. In addition, the taxpayer or a member of the
taxpayer’s family must have owned the property for
the three years immediately preceding the sale. The
provision would be effective for sales taking place after
December 31, 2003.
Increase Energy Production and Promote
Energy Conservation
Extend and modify the tax credit for producing
electricity from certain sources.—Taxpayers are provided a 1.5-cent-per-kilowatt-hour tax credit, adjusted
for inflation after 1992, for electricity produced from
wind, closed-loop biomass (organic material from a
plant grown exclusively for use at a qualified facility
to produce electricity), and poultry waste. To qualify
for the credit, the electricity must be sold to an unrelated third party and must be produced during the
first 10 years of production at a facility placed in service before January 1, 2002. The Administration proposes to extend the credit for electricity produced from
wind and biomass to facilities placed in service before
January 1, 2005. In addition, eligible biomass sources
would be expanded to include certain biomass from forest-related resources, agricultural sources, and other
specified sources. Special rules would apply to biomass
facilities placed in service before January 1, 2002. Electricity produced at such facilities from newly eligible
sources would be eligible for the credit only from January 1, 2002 through December 31, 2004, and at a rate

71
equal to 60 percent of the generally applicable rate.
Electricity produced from newly eligible biomass cofired in coal plants would also be eligible for the credit
only from January 1, 2002 through December 31, 2004,
and at a rate equal to 30 percent of the generally applicable rate. The Administration also proposes to modify
the rules relating to governmental financing of qualified
facilities. There would be no percentage reduction in
the credit for governmental financing attributable to
tax-exempt bonds. Instead, such financing would reduce
the credit only to the extent necessary to offset the
value of the tax exemption. The rules relating to leased
facilities would also be modified to permit the lessee,
rather than the owner, to claim the credit.
Provide tax credit for residential solar energy
systems.—Current law provides a 10-percent investment tax credit to businesses for qualifying equipment
that uses solar energy to generate electricity; to heat,
cool or provide hot water for use in a structure; or
to provide solar process heat. A credit currently is not
provided for nonbusiness purchases of solar energy
equipment. The Administration proposes a new tax
credit for individuals who purchase solar energy equipment to generate electricity (photovoltaic equipment)
or heat water (solar water heating equipment) for use
in a dwelling unit that the individual uses as a residence, provided the equipment is used exclusively for
purposes other than heating swimming pools. The proposed nonrefundable credit would be equal to 15 percent of the cost of the equipment and its installation;
each individual taxpayer would be allowed a maximum
credit of $2,000 for photovoltaic equipment and $2,000
for solar water heating equipment. The credit would
apply to photovoltaic equipment placed in service after
December 31, 2001 and before January 1, 2008 and
to solar water heating equipment placed in service after
December 31, 2001 and before January 1, 2006.
Modify treatment of 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 this limitation.
Also under current law, deductible contributions are
not permitted to exceed the amount the IRS determines
to be necessary to provide for level funding of an
amount equal to the taxpayer’s post-1983 decommissioning costs. The Administration proposes to permit
funding of all decommissioning costs through deductible
contributions. Any portion of these additional contributions relating to pre-1983 costs that exceeds the amount
previously deducted (other than under the nuclear decommissioning fund rules) or excluded from the taxpayer’s gross income on account of the taxpayer’s liability for decommissioning costs, would be allowed as a
deduction ratably over the remaining useful life of the
nuclear power plant.

72
The Administration’s proposal would also permit taxpayers to make deductible contributions to a qualified
fund after the end of the nuclear power plant’s estimated useful life and would provide that nuclear decommissioning costs are deductible when paid. These
changes in the treatment of nuclear decommissioning
funds are proposed to be effective for taxable years
beginning after December 31, 2001.
Provide tax credit for purchase of certain hybrid
and fuel cell 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. A qualified electric vehicle is a motor vehicle
that is powered primarily by an electric motor drawing
current from rechargeable batteries, fuel cells, or other
portable sources of electric current, the original use
of which commences with the taxpayer, and that is
acquired for use by the taxpayer and not for resale.
Electric vehicles and hybrid vehicles (those that have
more than one source of power on board the vehicle)
have the potential to reduce petroleum consumption,
air pollution and greenhouse gas emissions. To encourage the purchase of such vehicles, the Administration
is proposing the following tax credits: (1) A credit of
up to $4,000 would be provided for the purchase of
qualified hybrid vehicles after December 31, 2001 and
before January 1, 2008. The amount of the credit would
depend on the percentage of maximum available power
provided by the rechargeable energy storage system and
the amount by which the vehicle’s fuel economy exceeds
the 2000 model year city fuel economy. (2) A credit
of up to $8,000 would be provided for the purchase
of new qualified fuel cell vehicles after December 31,
2001 and before January 1, 2008. A minimum credit
of $4,000 would be provided, which would increase as
the vehicle’s fuel efficiency exceeded the 2000 model
year city fuel economy, reaching a maximum credit of
$8,000 if the vehicle achieved at least 300 percent of
the 2000 model year city fuel economy.
Provide tax credit for energy produced from
landfill gas.—Taxpayers that produce gas from biomass (including landfill methane) are eligible for a tax
credit equal to $3 per barrel-of-oil equivalent (the
amount of gas that has a British thermal unit content
of 5.8 million), adjusted by an inflation adjustment factor for the calendar year in which the sale occurs. To
qualify for the credit, the gas must be produced domestically from a facility placed in service by the taxpayer
before July 1, 1998, pursuant to a written binding contract in effect before January 1, 1997. In addition, the
gas must be sold to an unrelated person before January
1, 2008. The Administration proposes to extend the
credit to apply to landfill methane produced from a
facility (or portion of a facility) placed in service after
December 31, 2001 and before January 1, 2011, and
sold (or used to produce electricity that is sold) before
January 1, 2011. The credit for fuel produced at land-

ANALYTICAL PERSPECTIVES

fills subject to EPA’s 1996 New Source Performance
Standards/Emissions Guidelines would be limited to
two-thirds of the otherwise applicable amount beginning on January 1, 2008, if any portion of the facility
for producing fuel at the landfill was placed in service
before July 1, 1998, and beginning on January 1, 2002,
in all other cases.
Provide tax credit for combined heat and power
property.—Combined heat and power (CHP) systems
are used to produce electricity (and/or mechanical
power) and usable thermal energy from a single primary energy source. Depreciation allowances for CHP
property vary by asset use and capacity. No income
tax credit is provided under current law for investment
in CHP property. CHP systems utilize thermal energy
that is otherwise wasted in producing electricity by
more conventional methods and achieve a greater level
of overall energy efficiency, thereby lessening the consumption of primary fossil fuels, lowering total energy
costs, and reducing carbon emissions. To encourage increased energy efficiency by accelerating planned investments and inducing additional investments in such
systems, the Administration is proposing a 10-percent
investment credit for qualified CHP systems with an
electrical capacity in excess of 50 kilowatts or with
a capacity to produce mechanical power in excess of
67 horsepower (or an equivalent combination of electrical and mechanical energy capacities). A qualified
CHP system would be required to produce at least 20
percent of its total useful energy in the form of thermal
energy and at least 20 percent of its total useful energy
in the form of electrical or mechanical power (or a combination thereof) and would also be required to satisfy
an energy-efficiency standard. For CHP systems with
an electrical capacity in excess of 50 megawatts (or
a mechanical energy capacity in excess of 67,000 horsepower), the total energy efficiency would have to exceed
70 percent. For smaller systems, the total energy efficiency would have to exceed 60 percent. Investments
in qualified CHP assets that are otherwise assigned
cost recovery periods of less than 15 years would be
eligible for the credit, provided that the taxpayer elected to treat such property as having a 22-year class
life. The credit, which would be treated as an energy
credit under the investment credit component of the
general business credit, and could not be used in conjunction with any other credit for the same equipment,
would apply to investments in CHP property placed
in service after December 31, 2001 and before January
1, 2007.
Provide excise tax exemption (credit) for ethanol.—Under current law an income tax credit and
an excise tax exemption are provided for ethanol and
renewable source methanol used as a fuel. In general,
the income tax credit for ethanol is 53 cents per gallon,
but small ethanol producers (those producing less than
30 million gallons of ethanol per year) qualify for a
credit of 63 cents per gallon on the first 15 million
gallons of ethanol produced in a year. A credit of 60

4.

FEDERAL RECEIPTS

cents per gallon is allowed for renewable source methanol. As an alternative to the income tax credit, gasohol
blenders may claim a gasoline tax exemption of 53
cents for each gallon of ethanol and 60 cents for each
gallon of renewable source methanol that is blended
into qualifying gasohol. The rates for the ethanol credit
and exemption are each reduced by 1 cent per gallon
in 2003 and by an additional 1 cent per gallon in 2005.
The income tax credit expires on December 31, 2007
and the excise tax exemption expires on September 30,
2007. Neither the credit nor the exemption apply during
any period in which motor fuel taxes dedicated to the
Highway Trust Fund are limited to 4.3 cents per gallon.
The Administration proposes to extend both the income
tax credit and the excise tax exemption through December 31, 2010. The current law rule providing that neither the credit nor the exemption apply during any
period in which motor fuel taxes dedicated to the Highway Trust Fund are limited to 4.3 cents per gallon
would be retained.
Promote Trade
Extend and expand Andean trade preferences.—
The Administration proposes to renew and enhance the
Andean Trade Preference Act (ATPA), which expired
on December 4, 2001, through December 31, 2005. The
ATPA, which was enacted in 1991, was designed to
provide economic alternatives for Bolivia, Columbia, Ecuador, and Peru in their fight against narcotics production and trafficking.
Initiate a new trade preference program for
Southeast Europe.—The Administration is proposing
the Southeast Europe Trade Preference Act (SETPA),
which would initiate a new five-year trade preference
program for Southeast Europe, beginning October 1,
2002. The program is designed to rebuild the economies
of Southeast Europe that were harmed by recent ethnic
conflict in the area and will fulfill a commitment made
by the United States, along with our European partners, when we signed the Stability Pact for Southeast
Europe.
Implement free trade agreements with Chile and
Singapore.—Free trade agreements are expected to be
completed with Chile and Singapore in 2002, with tenyear implementation to begin in fiscal year 2003. These
agreements will benefit U.S. producers and consumers,
as well as strengthen the economies of Chile and Singapore. In addition, these agreements will establish precedents in our market opening efforts in two important
and dynamic regions - Latin America and Southeast
Asia.
Improve Tax Administration
Modify the IRS Restructuring and Reform Act
of 1998 (RRA98).—The proposed modification to
RRA98 is comprised of six parts. The first part modifies
employee infractions subject to mandatory termination

73
and permits a broader range of available penalties. It
strengthens taxpayer privacy while reducing employee
anxiety resulting from unduly harsh discipline or unfounded allegations. The second part adopts measures
to curb frivolous submissions and filings that are intended to impede or delay tax administration. The third
part allows IRS to terminate installment agreements
when taxpayers fail to make timely tax deposits and
file tax returns on current liabilities. The fourth part
streamlines jurisdiction over collection due process
cases in the Tax Court, thereby reducing the cycle time
for certain collection due process cases. The fifth part
permits taxpayers to enter into installment agreements
that do not guarantee full payment of liability over
the life of the agreement. It allows the IRS to enter
into agreements with taxpayers that desire to resolve
their tax obligations but cannot make payments large
enough to satisfy their entire liability and for whom
an offer in compromise is not a viable alternative. The
sixth part eliminates the requirement that the IRS
Chief Counsel provide an opinion for any accepted offerin-compromise of unpaid tax (including interest and
penalties) equal to or exceeding $50,000. This proposal
requires that the Treasury Secretary establish standards to determine when an opinion is appropriate.
Initiate IRS cost savings measures.—The Administration has six proposals to improve IRS efficiency
and performance from current resources. The first proposal permits the IRS to use certificates of mailing
as an alternative to certified mail for notices and letters
that currently require such mailing. The second proposal eliminates the requirement that notices of an intent to levy and right to a pre-levy hearing be sent
with return receipt requested, but retains the requirement that such notices be sent by certified or registered
mail or by first-class mail evidenced by a certificate
of mailing. These two proposals reduce postal costs
while retaining proof of first-class mailing. The third
proposal eliminates the requirement that dual notices
be sent to joint filers who reside at the same address.
The fourth proposal treats as nullities certain tax returns that the Criminal Investigation Division determines contain insufficient information to compute tax,
contain false information, or lack a valid signature.
Under this proposal, such returns that have been filed
to impede or delay tax administration are excluded
from deficiency procedures. The fifth proposal modifies
the way that Financial Management Services (FMS)
recovers its transaction fees for processing IRS levies
by permitting FMS to retain a portion of the amount
collected before transmitting the balance to the IRS.
The offset amount would be included as part of the
15-percent limit on levies against income and would
also be credited against the taxpayer’s liability, thereby
reducing Government transactions costs. Finally, the
sixth proposal extends the April filing date for electronically filed tax returns by at least ten days to help
encourage the growth of electronic filing.

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ANALYTICAL PERSPECTIVES

Reform Unemployment Insurance
Reform unemployment insurance administrative
financing.—Current law funds the administrative
costs of the unemployment insurance system and related programs out of the Federal Unemployment Tax
(FUTA) paid by employers. FUTA is set at 0.8 percent
of the first $7,000 in covered wages, which includes
a 0.2 percent surtax scheduled to expire in 2007. State
unemployment taxes are deposited into the Unemployment Trust Fund and used by States to pay unemployment benefits. Under current law, FUTA balances in
excess of statutory ceilings are distributed to the States
to pay unemployment benefits or the administrative
costs of the system (these are known as Reed Act transfers). The Administration supports an immediate distribution of $9 billion in Reed Act funds as part of
a bipartisan economic security plan. This would take
the place of the smaller Reed Act transfer projected
for October 1, 2002. In addition, the Administration
has a comprehensive proposal to reform the administrative financing of this system. It proposes to eliminate
the FUTA surtax in 2003, and make additional rate
cuts to achieve a net FUTA tax rate of 0.2 percent
in 2007. The proposal will transfer administrative funding control to the States in 2005 and allow them to
use their benefit taxes to pay these costs. Federal administrative grants to the States will be significantly
reduced. During the transition to State financing, special Reed Act distributions will be made to the States,
and additional Federal funds for administrative expenses will be provided.

include cash wages plus the cash value of certain employer-paid health, dependent care, and educational
fringe benefits. The minimum employment period that
employees must work before employers can claim the
credit is 400 hours. The Administration proposes to
extend the credit for two years, to apply to individuals
who begin work after December 31, 2001 and before
January 1, 2004.
Extend minimum tax relief for individuals.—A
temporary provision of prior law permits nonrefundable
personal tax credits to be offset against both the regular
tax and the alternative minimum tax. The temporary
provision expires after taxable year 2001. The Administration is concerned that the AMT may limit the benefit
of personal tax credits and impose financial and compliance burdens on taxpayers who have few, if any, tax
preference items and who were not the originally intended targets of the AMT. The Administration proposes to extend minimum tax relief for nonrefundable
personal tax credits two years, to apply to taxable years
2002 and 2003. The proposed extension does not apply
to the child credit, the earned income tax credit or
the adoption credit, which were provided AMT relief
through December 31, 2010 under the Economic Growth
and Tax Relief Reconciliation Act of 2001, as explained
above. The refundable portion of the child credit and
the earned income tax credit are also allowed against
the AMT through December 31, 2010.

Extend the work opportunity tax credit.—The
work opportunity tax credit provides an incentive for
employers to expand the number of entry level positions
for individuals from certain targeted groups. The credit
generally applies to the first $6,000 of wages paid to
several categories of economically disadvantaged or
handicapped workers. The credit rate is 25 percent of
qualified wages for employment of at least 120 hours
but less than 400 hours and 40 percent for employment
of 400 or more hours. The Administration proposes to
extend the credit for two years, making the credit available for workers hired after December 31, 2001 and
before January 1, 2004.

Extend 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, among other things, ‘‘foreign personal holding company income’’ and insurance income.
Foreign personal holding company income generally includes many types of income derived by a financial
service company, such as dividends; interest; royalties;
rents; annuities; net gains from the sale of certain property, including securities, commodities and foreign currency; and income from notional principal contracts and
securities lending activities. For taxable years beginning before 2002, certain income derived in the active
conduct of a banking, financing, insurance, or similar
business is excepted from Subpart F. The Administration proposes to extend the exception for two years,
to apply to taxable years beginning in 2002 and 2003.

Extend the welfare-to-work tax credit.—The welfare-to-work tax credit entitles employers to claim a
tax credit for hiring certain recipients of long-term family assistance. The purpose of the credit is to expand
job opportunities for persons making the transition
from welfare to work. 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 employment. Eligible wages

Extend suspension of net income limitation on
percentage depletion from marginal oil and gas
wells.—Taxpayers are allowed to recover their investment in oil and gas wells through depletion deductions.
For certain properties, deductions may be determined
using the percentage depletion method; however, in any
year, the amount deducted generally may not exceed
100 percent of the net income from the property. For
taxable years beginning after December 31, 1997 and

EXPIRING PROVISIONS
Extend Provisions that Expired in 2001 for Two
Years

4.

75

FEDERAL RECEIPTS

before January 1, 2002, domestic oil and gas production
from ‘‘marginal’’ properties is exempt from the 100-percent of net income limitation. The Administration proposes to extend the exemption to apply to taxable years
beginning after December 31, 2001 and before January
1, 2004.
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. The Administration proposes
to extend this program, which expired after September
30, 2001, through September 30, 2003.
Extend authority to issue Qualified Zone Academy Bonds.—Prior law allows State and local governments 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 must be used for teacher
training, purchases of equipment, curriculum development, or rehabilitation and repairs at certain public
school facilities. A nationwide total of $400 million of
qualified zone academy bonds was authorized to be

issued in each of calendar years 1998 through 2001.
In addition, unused authority arising in 1998 and 1999
may be carried forward for up to three years and unused authority arising in 2000 and 2001 may be carried
forward for up to two years. The Administration proposes to authorize the issuance of an additional $400
million of qualified zone academy bonds in each of calendar years 2002 and 2003.
Permanently Extend Expiring Provisions
Permanently extend provisions expiring in
2010.—As explained in the discussion of the Economic
Growth and Tax Relief Reconciliation Act of 2001, most
of the provisions of the Act sunset on December 31,
2010. The Administration proposes to permanently extend these provisions.
Permanently extend the research and experimentation (R&E) tax credit.—The Administration proposes to permanently extend the 20-percent tax credit
for qualified research and experimentation expenditures
above a base amount and the alternative incremental
credit, which are scheduled to expire on June 30, 2004.

TAX SIMPLIFICATION
In addition to the proposals summarized above, the
Administration is developing both short-term and
longer-term tax simplification proposals. The project to
develop short-term proposals, which is described below,
focuses on immediately achievable reforms of the current tax system, while the longer-term project focuses
on more fundamental reforms of the tax system.
As many recent studies and proposals have highlighted, the U.S. income tax system is extraordinarily
complex. Many taxpayers and businesses face significant challenges in understanding the tax laws, keeping
required records, and filling out numerous complicated
and detailed tax forms, which often require working
through lengthy abstruse instructions and cumbersome
calculations. Fortunately, our tax system is not complicated for everyone. Millions of taxpayers who have
relatively uncomplicated financial and family circumstances and are able to file form 1040EZ, for example, avoid most of the complexity of the tax system.
But for many others, coping with the tax system is
daunting. The need to deal with complexities in the
tax system is not limited to multinational corporations
or high-income investors with complex financial assets;
many taxpayers facing overwhelmingly complicated tax
situations are lower- and middle-income families, single
mothers, elderly people, small business owners and entrepreneurs.
Tax complexity is costly to taxpayers and the economy. Credible estimates of the cost to taxpayers of complying with the income tax range from $70 billion to
$125 billion per year. Additional costs may be imposed
on the economy if taxpayers avoid certain investments,

savings vehicles, business transactions, etc., because of
the tax complexities they would involve or because of
uncertainty about how the tax system would apply to
them. Extensive tax planning engaged in by some taxpayers and businesses is a wasteful use of resources.
Complexity makes it more costly for the IRS to administer the tax system. It makes it more difficult for the
IRS to train its staff, to give correct answers to increased numbers of taxpayers seeking help in understanding the tax laws, and to check and audit tax returns. These costs are a significant burden on the economy. Tax simplification can cut these costs and contribute to greater economic efficiency.
Tax complexity also may have other undesirable effects. Complexity may undermine confidence in the tax
system. If taxpayers conclude that the tax system is
so complex that no one can really figure it out, it will
destroy confidence that the tax system is accomplishing
its objectives, that other taxpayers are paying their fair
share of tax, and that the IRS can administer the system fairly. It may thereby undermine compliance with
the tax system and confidence in the government in
general. Reducing tax complexity is, therefore, an important policy objective.
But tax simplification is not simple. Complexity in
the tax system has not arisen merely because the writers of the tax laws have been inattentive or because
of a desire to provide jobs for tax accountants and lawyers. Many legitimate factors contribute to tax complexity. The modern, highly-productive U.S. economy
is very complex, and many taxpayers and companies
have complex financial and economic situations. Appli-

76

ANALYTICAL PERSPECTIVES

cation of the tax system to these complex financial and
economic arrangements is also unavoidably complex.
Many taxpayers have complex family arrangements or
have special circumstances that affect their needs or
their ability to pay taxes. Many special provisions have
been added to the tax system to recognize the special
circumstances of certain groups of taxpayers and adjust
their tax burdens accordingly. The tax system has also
been used extensively to provide incentives or benefits
for taxpayers engaging in certain kinds of activities
ranging from saving for retirement to saving energy
that are deemed to be socially beneficial. While all of
these tax provisions are well intended and presumptively have beneficial effects, they also contribute to
complexity in the tax system. At some point, the complexity itself detracts from the ability of the tax system
to function effectively and to accomplish these other
objectives.
Because of the multiple objectives involved in shaping
any particular tax provision, the effort to simplify the
tax system frequently involves tradeoffs. There may be
a few places in the tax code where it is possible to
draft less complex provisions that will accomplish all
of the policy objectives equally well or even better. Such
complexities may have arisen because of insufficient
time to draft less complex provisions as a tax bill was
being passed or because a series of provisions has been
enacted, revised, and added to over time without an
effort to consider the whole set of provisions and how
they could be combined and simplified to better achieve
their objectives. In many cases, however, simplification
will result in some compromise in achieving other policy
objectives, less precise targeting of a tax benefit, treatment of a type of income or expense in a way that
is less consistent with its true economic nature, etc.
In many areas, therefore, developing simplification proposals involves identifying areas of the tax system and
specific simplification schemes for which the simplification that can be achieved is regarded as more valuable
than the resulting decrease in achievement of other
policy goals.
The purpose of tax simplification, therefore, may be
stated succinctly as implementing changes that will reduce the compliance burden on taxpayers and/or administrative costs of the IRS while enhancing or resulting
in acceptably small sacrifices in the achievement of
other policy objectives such as efficiency, fairness, revenue, and enforceability.
The Administration has established the following objectives for the simplification project and principles for
developing the simplification proposals.
Objectives of Simplification
• To reduce burdens on taxpayers and the IRS.
• Greater economic growth.
• Increased voluntary compliance, including use of
the tax benefits provided by the law.
• Lower administrative and compliance costs.
• Fewer errors made by taxpayers and the IRS.

• Fewer inquiries taxpayers must make and the IRS
must handle.
• Fewer disputes between the IRS and taxpayers.
• Increased predictability (i.e., transparency) of the
tax law.
• Improvement of taxpayers’ confidence in the system.
• Similar treatment of similarly situated taxpayers.
• Similar treatment of transactions with similar economic results.
• Fewer complex and expensive tax planning strategies.
Principles for Developing Tax Simplification
Proposals
• Reduce or eliminate rules or requirements when
the cost of compliance and/or enforcement outweighs the benefits of the rules or requirements.
• Improve the readability of the law.
• Reduce overly technical and overly vague language
in the law.
• Avoid highly detailed conditions and requirements.
• Eliminate duplicative or overlapping provisions.
• Eliminate differing definitions of similar terms or
concepts.
• Reduce the amount of subjectivity necessary to
apply the tax law by providing clear rules and
clear distinctions.
• Reduce structural complexity.
• Reduce the number of phase-out provisions or coordinate the amounts in different phase-out provisions.
• Reduce the number and/or complexity of computations.
• Reduce record keeping and information gathering
requirements; coordinate record keeping and information gathering requirements with business
practices.
• Reduce inconsistencies in the law so that similarly
situated taxpayers are treated the same.
• Reduce distortions among economic activities.
• Eliminate provisions or rules no longer needed because other provisions or rules have changed or
because the provisions or rules are outdated.
• Reduce the number of temporary or sunset provisions.
Highest priority will be given to simplification proposals that will yield the largest benefits, i.e., that will
affect the most people and have the largest effects in
reducing compliance burdens and administrative costs.
Examples of areas in the tax system where the Administration’s tax simplification project is focusing include the following:
Individual AMT.—The AMT was enacted to ensure
that taxpayers with substantial amounts of economic
income do not avoid significant tax liability by using
combinations of exclusions, deductions, and tax credits.
Structural defects in the AMT, including lack of index-

4.

FEDERAL RECEIPTS

ing for inflation or adjustment for family size, have
resulted in the tax affecting millions of taxpayers to
whom it was not intended to apply. Millions of additional taxpayers must complete AMT schedules or forms
to determine that they are not subject to the AMT.
The number of taxpayers affected by the AMT and
the amount of revenue raised by the AMT are rising
rapidly, making simplification of the AMT an increasingly important objective of tax policy. This year, 2
million individual filers will be subject to the AMT and
therefore required to file the 65-line AMT form. The
temporary increase in the AMT exemption under
EGTRRA will reduce the increase in the number of
AMT taxpayers through 2004. Nevertheless, that number will increase to 5 million in 2004, and more than
double, increasing to 12 million in 2005 when the temporary provision expires. In 2005, 47 percent of taxpayers with AGI between $100,000 and $200,000 (in
2002 dollars) and 75 percent of taxpayers with AGI
between $200,000 and $500,000 (in 2002 dollars) will
pay AMT. By 2010, these percentages will increase to
90 percent and 96 percent, respectively. By 2012, the
number of AMT taxpayers will be 39 million (assuming
EGTRRA is extended), which is 34 percent of all taxpayers with individual income tax liability.
Family-related provisions.— Taxpayers with family responsibilities face confusing and sometimes conflicting rules. Many taxpayers are entitled to both the
EITC and the additional child tax credit. Both credits
are based on earned income and the number of children
in the family. But the two credits use different definitions of earned income, and different definitions of
qualifying children. Further, many taxpayers with three
or more children must compute the additional child
tax credit twice to determine which formula yields the
larger credit. Similarly, some taxpayers can offset the
costs of child care assistance using either a child and
dependent care tax credit or an exclusion from income,
but they must make multiple computations to determine which of the two is most advantageous. Conforming eligibility criteria and reducing the number of
computations taxpayers must make would help simplify
family-related tax provisions, thus reducing burdens on
families.
Uniform definition of a child.—The tax code provides assistance to families with children through the
dependent exemption, head-of-household filing status,
child tax credit, child and dependent care tax credit,
and EITC. But to obtain these benefits, taxpayers must
wade through pages of bewildering rules and instructions because each provision defines ‘‘qualifying child’’
differently. For example, to claim the dependent exemption and the child tax credit, a taxpayer must demonstrate that he or she provides most of the support
of the child. To claim the EITC, the taxpayer must
demonstrate that he or she resides with the child for
a specified period of time. Replacing the support test,
which is difficult to understand and to administer, with

77
a uniform residency test would reduce both compliance
and administrative costs.
Income based phaseouts.—Various tax provisions
are phased out in order to target the effects of the
provisions and to limit the associated revenue loss. The
major provisions subject to income-based phaseouts are
the EITC, the child tax credit, the child and dependent
care tax credit, IRAs, the HOPE and Lifetime Learning
tax credits, the deduction for higher-education expenses, the deduction for student loan interest, the exclusion for interest on education savings bonds, and
the adoption credit and exclusion. Two additional
phase-out provisions are scheduled to be reduced beginning in 2006 and eliminated completely in 2010: the
overall limitation on itemized deductions; and the
phaseout of personal exemptions. Phaseouts are complicated and increase marginal tax rates, sometimes
significantly. Complexity is increased even more by the
fact that different benefits are phased out differently.
As a result, taxpayers must often consider multiple
phase-out provisions.
Education incentives.—The various tax code provisions providing incentives for higher education use differing definitions of the various elements that make
up qualifying higher education expenses. The definitional differences add to the complexity taxpayers face
when they use the education incentives. The array of
education incentives from which taxpayers may choose
means further complexity.
Individual Retirement Accounts.—The current
multiple sets of IRA income limits are complex and
contain marriage penalties. The income limits complicate participation in IRAs by disallowing participation among certain workers depending on type of IRA,
income level, filing status, and both spouses’ coverage
under an employer retirement plan. Taxpayers need
to make year-end calculations to determine their eligibility for a deduction or contribution. Taxpayers in the
income range over which eligibility for the benefits
phases out need to make calculations to determine the
deductible portion of contributions to a traditional IRA,
or the allowable amount of contributions to a Roth IRA.
Taxpayers face uncertainty at the start of the year,
because they need to forecast their year-end income
to estimate their eligibility.
Individual capital gains.—Under current law,
long-term capital gains in excess of any short-term
losses are taxed separately from other income, and may
be taxed at 8, 10, 18, 20, 25 or 28 percent rates. Special
rules apply to collectibles, recapture of certain depreciation deductions, certain small business stock, principal
residences, certain investments in Enterprise Zones and
similar qualified zones, and certain like-kind exchanges.
These multiple capital gains rates and exclusions result
in complicated tax forms and schedules, and the need
for careful tax planning.

78
Excise taxes.—A number of excise taxes no longer
have a policy rationale, and in several cases involve
a significant number of taxpayers but generate relatively little revenue. Some excise taxes could be restructured to better accomplish policy objectives, reflect
recent technological changes, and reduce compliance
burdens for both taxpayers and the IRS. Other changes
would both improve excise tax compliance and simplify
their administration.
Tax-exempt bonds.—Two areas of the statutory taxexempt bond rules are particularly complex: the definition of a private activity bond and the arbitrage-related
provisions. The definition of a private activity bond
could be simplified without undoing the policy objective
of limiting the issuance of these bonds in tax-exempt
form. Compliance with arbitrage rules can be burdensome for issuers even in cases in which bond proceeds
are used for traditional governmental purposes. Simplifying changes could be made while still avoiding incentives for premature or over issuance of tax-exempt
bonds.
Corporate AMT.—The corporate AMT is a separate
tax regime within the Federal income tax system.
Under present law, corporations with average gross receipts of at least $7.5 million for the prior three years
are required to calculate their tax liability twice: once
using the rules of the regular tax system and a second
time using the corporate AMT rules. Under the corporate AMT rules, many of the advantageous deductions and credits allowed under the regular tax rules
are not allowed, but income under the AMT is taxed
at a lower rate than under the regular corporate tax
(20 percent, rather than 35 percent). If tax liability
calculated under the AMT rules exceeds regular tax
liability, the corporation is required to pay AMT in
addition to its regular tax. Because payment of AMT
represents a prepayment of regular tax, the amount
of AMT paid generates AMT credits that can be used
to offset regular tax in subsequent years (subject to
certain limitations).
The corporate AMT rules increase compliance burdens by causing corporations to devote additional resources to tax planning and record keeping. Because
the AMT rules limit the use of tax preferences only
for corporations that are AMT payers, corporations that
engage in tax-preferred activities incur expenditures to
develop strategies to minimize the effect of the AMT
rules. In addition, the AMT requires corporations to
keep extensive records of numerous adjustments and
preferences. For example, depreciation allowances for
newly invested property generally are calculated one
way under the regular tax and a different way under
the AMT. Although a corporation may not have AMT
liability, it is required to calculate the AMT to determine whether it owes AMT. The AMT tax regime is
difficult and burdensome for corporations to comply
with and for IRS to administer.

ANALYTICAL PERSPECTIVES

Depreciation.—There are several sources of complexity in tax depreciation. One source is ambiguity
in determining an asset’s class life, which determines
the asset’s annual depreciation allowance. New types
of assets, assets used in multiple activities, and building-related expenditures are sometimes difficult to classify and so lead to disputes between taxpayers and
the IRS. New assets may be particularly difficult to
fit within existing classification guidelines, which generally have not been updated since the mid-1980s.
Placed-in-service conventions also can add to complexity and create uncertainty. Generally, an asset does
not receive a full year’s depreciation during the tax
year in which it is initially placed in service. Instead,
the asset receives a fraction of the annual depreciation
allowances, as determined by the date on which statutory convention deems the asset to have been placed
in service. The placed-in-service conventions sometimes
require taxpayers to wait until the end of the taxable
year to determine the proper depreciation allowance
for property that may have been placed in service at
various dates throughout the year.
Capitalization.— Substantial ambiguity exists over
whether many items of cost may be deducted currently
or instead must be capitalized. Case law holds that
the determination of whether an item of cost must be
capitalized is based on each particular taxpayer’s facts
and circumstances. While no one factor has been held
to be determinative, the current legal standard relies
heavily on whether the item creates a significant future
benefit, but the degree of future benefit required for
capitalization is ambiguous. Thus, taxpayers and the
IRS may end up in dispute over whether certain costs,
which traditionally have been deducted, should instead
be capitalized. The present uncertain legal environment
has elevated capitalization to the top of the list of contested audit issues for businesses.
Tax accounting.—There are many sources of complexity in tax accounting. These include issues related
to accrual and inventory accounting, uniform capitalization rules, and the percentage of completion method.
Compliance problems generally are more severe for
small companies.
Accrual accounting and inventory accounting can be
complex and add to the burden of complying with the
tax law, especially for small taxpayers. Some of this
complexity arises from the additional record keeping
required to measure taxes on an accrual basis when
the taxpayer uses cash accounting for financial reporting. Additional complexity arises from legal ambiguities
about whether certain taxpayers are required to keep
inventory accounts. Recently implemented IRS Revenue
Procedures provide substantial simplification and certainty by exempting many small taxpayers from the
record-keeping burdens of accrual and inventory accounting. For small businesses that do not qualify for
tax relief under these Procedures, however, accrual and
inventory accounting may continue to impose complexity and record keeping costs.

4.

79

FEDERAL RECEIPTS

The LIFO (Last In First Out, a method of accounting
for inventories) conformity requirement, that requires
firms to use the LIFO method for financial reporting
when they use LIFO for tax accounting, also adds to
complexity. Conformity violations are more a matter
of how information is provided than of what information is provided, creating complications and traps for
the unwary.
The uniform capitalization (UNICAP) rules require
that both direct and indirect costs be added to basis
or included in inventory. Measuring and accounting for
all capitalizable costs can be difficult, especially for
small taxpayers. Yet, for many taxpayers the UNICAP
rules have only a small effect on tax liability, compared
to simpler methods, and so add to complexity without
substantially affecting tax results.
The percentage of completion method used for determining income from a long-term contract requires the
taxpayer to estimate costs and receipts over the life
of the contract, with timing errors corrected by a lookback adjustment once the contract is completed. The
Table 4–3.

calculations and record keeping required can be burdensome, especially for small taxpayers. Moreover, in some
cases simpler tax accounting methods would cause only
a small reduction in tax liability.
International tax rules.—There is much that can
be done to reduce the complexity of our international
tax rules. This area of the tax law is singled out by
businesses as one of the biggest sources of administrative complexity and compliance costs. Moreover, the
global economy has changed dramatically since the U.S.
international tax rules were developed. It is time to
re-examine the rules with a view toward significant
rationalization. The focus of efforts in this area will
be to reduce the instances in which the international
tax rules impose conditions or requirements on U.S.
taxpayers that are not consistent with the way businesses operate in the global marketplace and that require efforts that otherwise are unnecessary or noneconomic.

EFFECT OF PROPOSALS ON RECEIPTS
(In millions of dollars)
Estimate

Plan 1

Bipartisan Economic Security
...............................................................
Tax Incentives:
Provide incentives for charitable giving:
Provide charitable contribution deduction for nonitemizers ........................
Permit tax-free withdrawals from IRAs for charitable contributions ...........
Raise the cap on corporate charitable contributions ..................................
Expand and increase the enhanced charitable deduction for contributions of food inventory .............................................................................
Reform excise tax based on investment income of private foundations ...
Modify tax on unrelated business taxable income of charitable remainder trusts ..................................................................................................
Modify basis adjustment to stock of S corporations contributing appreciated property .........................................................................................
Allow expedited consideration of applications for exempt status 2 ............
Strengthen and reform education:
Provide refundable tax credit for certain costs of attending a different
school for pupils assigned to failing public schools 3 ............................
Allow teachers to deduct out-of-pocket classroom expenses ....................
Invest in health care:
Provide refundable tax credit for the purchase of health insurance 4 .......
Provide an above-the-line deduction for long-term care insurance premiums .......................................................................................................
Allow up to $500 in unused benefits in a health flexible spending arrangement to be carried forward to the next year .................................
Provide additional choice with regard to unused benefits in a health
flexible spending arrangement ................................................................
Permanently extend and reform Archer MSAs ...........................................
Provide an additional personal exemption to home caretakers of family
members ..................................................................................................
Assist Americans with disabilities:
Exclude from income the value of employer-provided computers, software and peripherals ...............................................................................
Help farmers and fishermen manage economic downturns:
Establish FFARRM savings accounts .........................................................
Increase housing opportunities:
Provide tax credit for developers of affordable single-family housing .......
Encourage saving:
Establish Individual Development Accounts (IDAs) ....................................

2002

2003

2004

2005

2006

2007

2003–2007

2003–2012

–62,000

–65,000

–47,500

–9,500

17,000

18,000

–87,000

–43,500

–570
–93
–24

–1,429
–192
–169

–1,437
–205
–121

–2,288
–219
–127

–3,567
–230
–139

–3,591
–238
–156

–12,312
–1,084
–712

–32,636
–2,632
–1,730

–10
–122

–49
–177

–54
–181

–59
–189

–66
–198

–72
–205

–300
–950

–789
–2,101

–1

–3

–3

–4

–4

–4

–18

–48

–8
..............

–11
..............

–13
..............

–17
................

–21
................

–25
................

–87
..................

–282
....................

..............
..............

–10
..............

–24
–16

–38
–163

–52
–191

–62
–207

–186
–577

–219
–1,718

..............

–245

–1,689

–2,811

–2,774

–2,951

–10,470

–29,116

..............

–328

–406

–605

–1,222

–2,158

–4,719

–20,730

..............

..............

–441

–723

–782

–830

–2,776

–7,819

..............
..............

..............
..............

–23
–43

–39
–468

–45
–530

–52
–607

–159
–1,648

–566
–5,691

..............

–314

–383

–362

–345

–348

–1,752

–3,957

..............

..............

–2

–6

–6

–6

–20

–52

..............

..............

–133

–350

–244

–171

–898

–1,233

..............

–7

–76

–302

–715

–1,252

–2,352

–15,257

..............

–124

–267

–319

–300

–255

–1,265

–1,722

80

ANALYTICAL PERSPECTIVES

Table 4–3.

EFFECT OF PROPOSALS ON RECEIPTS—Continued
(In millions of dollars)
Estimate

Protect the environment:
Permanently extend expensing of brownfields remediation costs .............
Exclude 50 percent of gains from the sale of property for conservation
purposes ..................................................................................................
Increase energy production and promote energy conservation:
Extend and modify tax credit for producing electricity from certain
sources .....................................................................................................
Provide tax credit for residential solar energy systems .............................
Modify treatment of nuclear decommissioning funds .................................
Provide tax credit for purchase of certain hybrid and fuel cell vehicles ...
Provide tax credit for energy produced from landfill gas ...........................
Provide tax credit for combined heat and power property ........................
Provide excise tax exemption (credit) for ethanol 2 ....................................
Promote trade:
Extend and expand Andean trade preferences 5 .......................................
Initiate a new trade preference program for Southeast Europe 5 ..............
Implement free trade agreements with Chile and Singapore 5 ..................
Improve tax administration:
Implement IRS administrative reforms ........................................................
Reform unemployment insurance:
Reform unemployment insurance administrative financing 5 ......................
Expiring Provisions:
Extend provisions that expired in 2001 for two years:
Work opportunity tax credit .........................................................................
Welfare-to-work tax credit ............................................................................
Minimum tax relief for individuals ................................................................
Exceptions provided under Subpart F for certain active financing income
Suspension of net income limitation on percentage depletion from marginal oil and gas wells ............................................................................
Generalized System of Preferences (GSP) 5 ..............................................
Authority to issue qualified zone academy bonds ......................................
Permanently extend expiring provisions:
Provisions expiring in 2010:
Marginal individual income tax rate reductions ......................................
Child tax credit 6 ......................................................................................
Marriage penalty relief 7 ..........................................................................
Education incentives ................................................................................
Repeal of estate and generation-skipping transfer taxes, and modification of gift taxes .............................................................................
Modifications of IRAs and pension plans ...............................................
Other incentives for families and children ..............................................
Research and experimentation (R&E) tax credit ........................................
Total effect of proposals ..........................................................................
1 Affects

2002

2003

2004

2005

2006

2007

2003–2007

2003–2012

..............

..............

–193

–306

–299

–289

–1,087

–2,390

..............

–2

–44

–90

–94

–98

–328

–918

–92
–3
–89
–21
–12
–97
..............

–227
–6
–156
–80
–34
–208
..............

–303
–7
–168
–181
–59
–235
..............

–212
–8
–178
–349
–86
–238
................

–143
–17
–188
–530
–120
–296
................

–146
–24
–199
–763
–140
–139
................

–1,031
–62
–889
–1,903
–439
–1,116
..................

–1,779
–72
–2,042
–3,027
–1,130
–1,091
....................

–130
..............
..............

–192
–19
–21

–213
–23
–86

–226
–25
–109

–58
–7
–131

................
................
–155

–689
–74
–502

–689
–74
–1,560

..............

60

49

50

52

54

265

559

..............

–1,002

–1,451

–2,902

–2,982

–4,429

–12,766

–6,924

–43
–9
–122
–864

–153
–37
–353
–1,502

–200
–57
–256
–630

–127
–48
................
................

–60
–32
................
................

–29
–22
................
................

–569
–196
–609
–2,132

–576
–209
–609
–2,132

–25
–370
–4

–44
–415
–13

–18
..............
–25

................
................
–35

................
................
–37

................
................
–37

–62
–415
–147

–62
–415
–332

..............
..............
..............
–1

..............
..............
..............
–5

..............
..............
..............
–10

................
................
................
–15

................
................
................
–20

................
................
................
–26

..................
..................
..................
–76

–183,769
–31,697
–12,976
–2,810

178
..............
..............
..............

–550
..............
..............
..............

–1,097
..............
..............
–906

–1,485
................
................
–2,949

–1,987
................
................
–4,654

–2,178
................
................
–5,623

–7,297
..................
..................
–14,132

–103,659
–6,490
–1,298
–51,051

–64,532

–73,017

–59,130

–27,927

–6,034

–9,433

–175,541

–591,020

both receipts and outlays. Only the receipt effect is shown here. The outlay effect is $27,000 million for 2002, $8,000 for 2003, $1,500 million for 2004, $9,500 million for 2003–2007, and $9,500 million for 2003–2012.
proposal with a receipt effect of zero.
3 Affects both receipts and outlays. Only the receipt effect is shown here. The outlay effect is $165 million for 2003, $449 million for 2004, $699 million for 2005, $975 million for 2006, $1,213 million for 2007, $3,501 million
for 2003–2007, and $4,155 million for 2003–2012.
4 Affects both receipts and outlays. Only the receipt effect is shown here. The outlay effect is $667 million for 2003, $5,185 million for 2004, $6,292 million for 2005, $6,560 million for 2006, $6,441 million for 2007, $25,145
million for 2003–2007, and $59,873 million for 2003–2012.
5 Net of income offsets.
6 Affects both receipts and outlays. Only the receipt effect is shown here. The outlays effect is $8,745 million for 2003–2012.
7 Affects both receipts and outlays. Only the receipt effect is shown here. The outlays effect is $1,527 million for 2003–2012,
2 Policy

4.

81

FEDERAL RECEIPTS

Table 4–4. RECEIPTS BY SOURCE
(In millions of dollars)

Source

Estimate

2001
Actual

2002

2003

2004

2005

2006

2007

Individual income taxes (federal funds):
Existing law ............................................................................................................................
994,339
Proposed Legislation (PAYGO) ........................................................................................ ..................

949,885
–646

1,009,047
–2,693

1,063,560
–4,966

1,119,913
–7,904

1,167,409
–10,133

1,233,065
–11,378

Total individual income taxes ................................................................................................

994,339

949,239

1,006,354

1,058,594

1,112,009

1,157,276

1,221,687

Corporation income taxes:
Federal funds:
Existing law .......................................................................................................................
151,071
Proposed Legislation (PAYGO) .................................................................................... ..................

202,547
–1,102

207,960
–2,471

215,170
–3,182

241,952
–4,865

248,397
–6,949

258,890
–8,275

201,445

205,489

211,988

237,087

241,448

250,615

Total Federal funds corporation income taxes .....................................................................
Trust funds:
Hazardous substance superfund ......................................................................................
Total corporation income taxes .............................................................................................

151,071

4 .................. .................. .................. .................. .................. ..................
151,075

201,445

205,489

211,988

237,087

241,448

250,615

434,057
73,462
149,651

442,131
75,067
151,677

466,185
79,158
159,310

490,228
83,244
167,667

519,907
88,286
178,255

541,680
91,984
185,997

568,723
96,576
195,448

1,614
2,658

1,704
2,556

1,721
2,412

1,749
2,307

1,771
2,299

1,795
2,332

1,818
2,366

Total employment and general retirement ............................................................................

661,442

673,135

708,786

745,195

790,518

823,788

864,931

On-budget ..........................................................................................................................
Off-budget ..........................................................................................................................

153,923
507,519

155,937
517,198

163,443
545,343

171,723
573,472

182,325
608,193

190,124
633,664

199,632
665,299

Unemployment insurance:
Deposits by States 1 .........................................................................................................
20,824
23,254
Proposed Legislation (PAYGO) .................................................................................... .................. ..................
Federal unemployment receipts 1 ....................................................................................
6,937
6,934
Proposed Legislation (PAYGO) .................................................................................... .................. ..................
Railroad unemployment receipts 1 ...................................................................................
51
100

29,887
–1
7,065
–1,252
150

34,564
–5
7,237
–1,809
156

36,363
–462
7,410
–3,165
120

36,744
63
7,580
–3,790
94

36,914
–289
7,749
–5,247
103

Total unemployment insurance .............................................................................................

27,812

30,288

35,849

40,143

40,266

40,691

39,230

Other retirement:
Federal employees’ retirement—employee share ............................................................
Non-Federal employees retirement 2 ...............................................................................

4,647
66

4,550
62

4,527
50

4,424
46

4,337
42

4,221
39

4,068
36

Total other retirement ............................................................................................................

4,713

4,612

4,577

4,470

4,379

4,260

4,104

Total social insurance and retirement receipts ...................................................................

693,967

708,035

749,212

789,808

835,163

868,739

908,265

On-budget ..............................................................................................................................
Off-budget ..............................................................................................................................

186,448
507,519

190,837
517,198

203,869
545,343

216,336
573,472

226,970
608,193

235,075
633,664

242,966
665,299

Excise taxes:
Federal funds:
Alcohol taxes .....................................................................................................................
7,624
Tobacco taxes ...................................................................................................................
7,396
Transportation fuels tax ....................................................................................................
1,150
Telephone and teletype services ......................................................................................
5,769
Ozone depleting chemicals and products ........................................................................
32
Other Federal fund excise taxes ......................................................................................
2,151
Proposed Legislation (PAYGO) .................................................................................... ..................

7,627
8,045
1,138
5,984
22
1,963
–122

7,664
8,115
1,180
6,345
13
1,867
–177

24,657

25,007

25,371

25,873

25,353

25,802

Trust funds:
Highway .............................................................................................................................
31,469
31,926
32,952
Proposed Legislation (PAYGO) .................................................................................... .................. .................. ..................

34,121
–7

35,414
–17

36,919
–29

38,038
–38

Social insurance and retirement receipts (trust funds):
Employment and general retirement:
Old-age and survivors insurance (Off-budget) .................................................................
Disability insurance (Off-budget) .......................................................................................
Hospital insurance .............................................................................................................
Railroad retirement:
Social Security equivalent account ..............................................................................
Rail pension and supplemental annuity .......................................................................

Total Federal fund excise taxes ...........................................................................................

24,122

7,748
7,831
7,877
7,923
7,974
7,875
7,782
7,692
1,216
1,266
304
312
6,753
7,179
7,612
8,050
7 .................. .................. ..................
1,854
1,911
1,976
2,030
–181
–189
–198
–205

82

ANALYTICAL PERSPECTIVES

Table 4–4. RECEIPTS BY SOURCE—Continued
(In millions of dollars)

Source
Airport and airway .............................................................................................................
Aquatic resources ..............................................................................................................
Black lung disability insurance .........................................................................................
Inland waterway ................................................................................................................
Hazardous substance superfund ......................................................................................
Vaccine injury compensation ............................................................................................
Leaking underground storage tank ...................................................................................

2001
Actual

Estimate
2002

2003

2004

2005

2006

2007

9,191
8,939
9,680
10,269
10,878
11,518
12,178
358
385
393
414
424
435
443
522
554
573
597
616
628
638
113
97
98
98
99
100
101
2 .................. .................. .................. .................. .................. ..................
112
123
125
125
127
128
129
179
190
193
199
204
214
218

Total trust funds excise taxes ...............................................................................................

41,946

42,214

44,014

45,816

47,745

49,913

51,707

Total excise taxes ....................................................................................................................

66,068

66,871

69,021

71,187

73,618

75,266

77,509

Estate and gift taxes:
Federal funds .........................................................................................................................
28,400
Proposed Legislation (PAYGO) ........................................................................................ ..................

27,484
6

23,559
–560

27,638
–1,050

24,769
–1,343

28,121
–1,736

24,992
–1,794

Total estate and gift taxes ......................................................................................................

28,400

27,490

22,999

26,588

23,426

26,385

23,198

Customs duties:
Federal funds .........................................................................................................................
18,583
Proposed Legislation (PAYGO) ........................................................................................ ..................
Trust funds .............................................................................................................................
786

18,538
–668
796

19,781
–863
887

21,424
–430
905

22,549
–482
977

23,964
–262
1,041

25,283
–207
1,075

Total customs duties ...............................................................................................................

19,369

18,666

19,805

21,899

23,044

24,743

26,151

MISCELLANEOUS RECEIPTS: 3
Miscellaneous taxes ..............................................................................................................
United Mine Workers of America combined benefit fund ....................................................
Deposit of earnings, Federal Reserve System ....................................................................
Defense cooperation ..............................................................................................................
Fees for permits and regulatory and judicial services .........................................................
Fines, penalties, and forfeitures ............................................................................................
Gifts and contributions ..........................................................................................................
Refunds and recoveries ........................................................................................................

94
150
26,124
7
8,483
2,724
284
–54

109
143
25,596
6
7,905
2,685
244
–298

111
138
29,025
6
8,463
2,523
219
–305

113
132
31,512
6
8,650
2,509
185
–317

115
127
32,084
6
8,478
2,517
186
–325

117
123
33,214
6
8,607
2,525
179
–327

119
117
34,832
6
8,794
2,534
180
–335

Total miscellaneous receipts .................................................................................................

37,812

36,390

40,180

42,790

43,188

44,444

46,247

Proposed bipartisan economic security plan (PAYGO) ..................................................... ..................

–62,000

–65,000

–47,500

–9,500

17,000

18,000

Total budget receipts ..............................................................................................................
On-budget ..............................................................................................................................
Off-budget ..............................................................................................................................

1,991,030
1,483,511
507,519

1,946,136
1,428,938
517,198

2,048,060
1,502,717
545,343

2,175,354
1,601,882
573,472

2,338,035
1,729,842
608,193

2,455,301
1,821,637
633,664

2,571,672
1,906,373
665,299

MEMORANDUM
Federal funds .........................................................................................................................
Trust funds .............................................................................................................................
Interfund transactions ............................................................................................................

1,255,504
445,470
–217,463

1,195,158
465,179
–231,399

1,255,629
497,771
–250,683

1,338,515
518,623
–255,256

1,453,879
542,161
–266,198

1,535,377
564,491
–278,231

1,610,437
587,613
–291,677

Total on-budget ........................................................................................................................

1,483,511

1,428,938

1,502,717

1,601,882

1,729,842

1,821,637

1,906,373

Off-budget (trust funds) ..........................................................................................................

507,519

517,198

545,343

573,472

608,193

633,664

665,299

Total ...........................................................................................................................................

1,991,030

1,946,136

2,048,060

2,175,354

2,338,035

2,455,301

2,571,672

1 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.

5. USER FEES AND OTHER COLLECTIONS
In addition to collecting taxes and other receipts by
the exercise of its sovereign powers, which is discussed
in the previous chapter, the Federal Government collects income from the public from market-oriented activities and the financing of regulatory expenses. Some
of these collections are classified as user fees, which
include the sale of postage stamps and electricity, fees
for admittance to national parks, and premiums for
deposit insurance; and some are other offsetting collections or receipts, such as rents and royalties for the
right to extract oil from the Outer Continental Shelf.
Depending on the laws that authorize the collections,
the collections can be credited directly to expenditure
accounts as ‘‘offsetting collections,’’ or to receipt accounts as ‘‘offsetting receipts.’’ Usually offsetting collections are authorized to be spent for the purposes of
the account without further action by the Congress.
Offsetting receipts may or may not be earmarked for
a specific purpose, depending on the legislation that
authorizes them, and the authorizing legislation may
either authorize them to be spent without further action by the Congress, or require them to be appropriated in annual appropriations acts before they can
be spent.

The budget refers to them as offsetting collections
and offsetting receipts, because they are subtracted
from gross outlays rather than added to taxes on the
receipts side of the budget. 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. 1
Offsetting collections and receipts include most user
fees, which are discussed below, as well as some
amounts that are not user fees. Table 5–1 summarizes
these transactions. For 2003, total offsetting collections
and receipts from the public are estimated to be $231.2
billion, and total user fees are estimated to be $154.3
billion.
The following section discusses user fees and the Administration’s user fee proposals. The subsequent section displays more information on offsetting collections
and receipts. The offsetting collections and receipts by
agency are also displayed in Table 21–1, ‘‘Outlays to
the Public, Net and Gross,’’ which appears in Chapter
21 of this volume.

Table 5–1. GROSS OUTLAYS, USER FEES, OTHER OFFSETTING
COLLECTIONS AND RECEIPTS FROM THE PUBLIC, AND NET OUTLAYS
(In billions of dollars)
2001
Actual

Estimate
2002

2003

Gross outlays ......................................................................................
Offsetting collections and receipts from the public:
User fees 1 .................................................................................
Other ..........................................................................................

2,084.5

2,275.7

2,359.5

–132.1
–88.4

–140.2
–83.2

–152.7
–78.5

Subtotal, offsetting collections and receipts from the public ........

–220.6

–223.4

–231.2

Net outlays ..........................................................................................

1,863.9

2,052.3

2,128.2

1 Total user fees are shown below. They include user fees that are classified on the receipts side of the
budget in addition to the amounts shown on this line. For additional details of total user fees, see table 5–2.
‘‘Total User Fee Collections.’’

Total user fees:
Offsetting collections and receipts from the public ......................................
Receipts .........................................................................................................

132.1
1.5

140.2
1.5

152.7
1.6

Total, user fees ..................................................................................................

133.7

141.6

154.3

1 Showing collections from business-type transactions as offsets on the spending side of
the budget follows the concept recommended by the 1967 Report of the President’s Commis-

sion on Budget Concepts. The concept is discussed in Chapter 25: ‘‘Budget System and
Concepts and Glossary’’ in this volume.

83

84

ANALYTICAL PERSPECTIVES

USER FEES
I. Introduction and Background
The Federal Government may charge user fees to
those who benefit directly from a particular activity
or those subject to regulation. According to the definition of user fees used in this chapter, Table 5–2 shows
that user fees were $133.7 billion in 2001, and are
estimated to increase to $141.6 billion in 2002 and to
$154.3 billion in 2003, growing to an estimated $176.9
billion in 2007, including the user fee proposals that
are shown in Table 5–3. This table shows that the
Administration is proposing to increase user fees by
an estimated $1.5 billion in 2003, growing to an estimated $2.9 billion in 2007.
Definition. The term ‘‘user fee’’ as defined here is
fees, charges, and assessments levied on groups or individuals directly benefitting from, or subject to regulation by, a government program or activity, and 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 it is charged, including
directly associated agency functions, not for unrelated
programs or activities and not for the broad purposes
of the Government or an agency.
• Examples of business-type or market-oriented user
fees include fees for the sale of postal services
(the sale of stamps), electricity (e.g., sales by the
Tennessee Valley Authority), payments for Medicare voluntary supplemental medical insurance,
life insurance premiums for veterans, recreation
fees for parks, NASA fees for shuttle services, the
sale of weather maps and related information by
the Department of Commerce, the sale of commemorative coins, and fees for the sale of books.
• Examples of regulatory and licensing user fees include fees for regulating the nuclear energy industry, bankruptcy filing fees, immigration fees, food
inspection fees, passport fees, and patent and
trademark fees.
User fees do not include all offsetting collections and
receipts, such as the interest and repayments received
from credit programs; proceeds from the sale of loans
and other financial investments; interest, dividends,
and other earnings; cost sharing contributions; the sale
of timber, minerals, oil, commodities, and other natural
resources; proceeds from asset sales (property, plant,
and equipment); Outer Continental Shelf receipts; or
spectrum auction proceeds. Neither do they include earmarked taxes (such as taxes paid to social insurance
programs or excise taxes), or customs duties, fines, penalties, and forfeitures.
Alternative definitions. The definition used in this
chapter is useful because it identifies goods, services,
and regulations financed by earmarked collections and

receipts.2 Other definitions may be used for other purposes. Much of the discussion of user fees below—their
purpose, when they should be levied, and how the
amount should be set—applies to these alternatives as
well.
OMB uses the broader concept of ‘‘user charges’’ to
establish policy for charging prices to the public for
the sale or use of goods, services, property, and resources (see OMB Circular A–25, ‘‘User Charges,’’ July
8, 1993). User charges are all amounts assessed for
the provision of Government services and for the sale
or use of Government goods, property, or resources.
The payers of the user charge must be limited in the
authorizing legislation to those receiving special benefits from, or subject to regulation by, the program or
activity beyond the benefits received by the general
public or broad segments of the public (such as those
who pay income taxes or customs duties). The term
is broader than user fees as defined in this chapter
in two ways. First, user charges encompass proceeds
from the sale of government goods and services regardless of whether they are earmarked to fund the specific
program or activity for which they are charged. Second,
the term includes proceeds from the sale of natural
resources (such as timber, oil, and minerals) and asset
sales (such as property, plant, and equipment) as well
as goods and services.
Other alternative definitions of user fees could, for
example:
• be narrower than the one used here, by excluding
regulatory fees and analyzing them as a separate
category.
• interpret more broadly whether a program has
private beneficiaries, or whether the proceeds are
earmarked to benefit directly those paying the fee.
A
broader
interpretation
might
include
beneficiary- or liability-based excise taxes.3
What is the purpose of user fees? The purpose
of user fees is to improve the efficiency and equity
of certain Government activities, and to reduce the burden on the taxpayer to finance activities whose benefits
accrue to a relatively limited number of people.
User fees that are set to cover the costs of production
of goods and services can provide efficiency in the allocation of resources within the economy. They allocate
goods and services to those who value them the most,
and they signal to the Government how much of the
goods or services it should provide. Prices in private,
competitive markets serve the same purposes.
2 The definition of user fees used here is similar to one the House of Representatives
uses as a guide for purposes of committee jurisdiction. The definition helps differentiate
between taxes, which are under the jurisdiction of the Ways and Means Committee, and
fees, which can be under the jurisdiction of other committees. See the Congressional Record,
January 3, 1991, p. H31, item 8.
3 Beneficiary- and liability-based taxes are terms taken from the Congressional Budget
Office, The Growth of Federal User Charges, August 1993, and updated in October 1995.
Examples of beneficiary-based taxes include taxes on gasoline, which finance grants to
States for highway construction, or taxes on airline tickets, which finance air traffic control
activities and airports. An example of a liability-based tax is the excise tax that formerly
helped fund the hazardous substance superfund in the Environmental Protection Agency.
This tax was paid by industry groups to finance environmental cleanup activities related
to the industry activity but not necessarily caused by the payer of the fee.

5. USER FEES AND OTHER COLLECTIONS

User fees for goods and services that do not have
special social benefits improve equity, or fairness, by
requiring that those who benefit from an activity are
the same people who pay for it. The public often perceives user fees as fair because those who benefit from
the good or service pay for it in whole or in part,
and those who do not benefit do not pay.
When should the Government charge a fee? Discussions of whether to finance spending with a tax or
a fee often focus on whether the benefits of the activity
are to the public in general or to a limited group of
people. In general, if the benefits accrue broadly to
the public, then the program should be financed by
taxes paid by the public; in contrast, if the benefits
accrue to a limited number of private individuals or
groups, then the program should be financed by fees
paid by the private beneficiaries. For Federal programs
where the benefits are entirely public or entirely private, applying this principle is relatively easy. For example, according to this principle, the benefits from
national defense accrue to the public in general and
should be (and are) financed by taxes. In contrast, the
benefits of electricity sold by the Tennessee Valley Authority accrue exclusively to those using the electricity,
and should be (and are) financed by user fees.
In many cases, however, an activity has benefits that
accrue to both public and to private groups, and it
may be difficult to identify how much of the benefits
accrue to each. Because of this, it can be difficult to
know how much of the program should be financed
by taxes and how much by fees. For example, the benefits from recreation areas are mixed. Fees for visitors
to these areas are appropriate because the visitors benefit directly from their visit, but the public in general
also benefits because these areas protect the Nation’s
natural and historical heritage now and for posterity.
As a further complication, where a fee may be appropriate to finance all or part of an activity, some consideration must be given to the ease of administering the
fee.
What should be the amount of the fee? For programs that have private beneficiaries, the amount of
the fee should depend on the costs of producing the
goods or services and the portion of the program that
is for private benefits. If the benefit is primarily private, and any public benefits are incidental, current
policies support fees that cover the full cost to the Government, including both direct and indirect costs.4
The Executive Branch is working to put cost accounting systems in place across the Government that would
make the calculation of full cost more feasible. The
difficulties in measuring full cost are associated in part
with allocating to an activity the full costs of capital,
retirement benefits, and insurance, as well as other
Federal costs that may appear in other parts of the
budget. Guidance in the Statement of Federal Financial
Accounting Standards No. 4, Managerial Cost Account4 Policies for setting user charges are promulgated in OMB Circular No. A–25: ‘‘User
Charges’’ (July 8, 1993). These policies are required regardless of whether or not the proceeds
are earmarked to finance the related activity.

85
ing Concepts and Standards for the Federal Government (July 31, 1995), should underlie cost accounting
in the Federal Government.
Classification of user fees in the budget. As
shown in Table 5–1, most user fees are classified as
offsets to outlays on the spending side of the budget,
but a few are classified on the receipts side of the
budget. An estimated $1.6 billion in 2003 are classified
this way and are included in the totals described in
Chapter 4. ‘‘Federal Receipts.’’ They are classified as
receipts because they are regulatory fees collected by
the Federal Government by the exercise of its sovereign
powers.
The remaining user fees, an estimated $152.7 billion
in 2003, are classified as offsetting collections and receipts on the spending side of the budget. Some of these
are collected by the Federal Government by the exercise
of its sovereign powers and would normally appear on
the receipts side of the budget, but are required by
law to be classified as offsetting collections or receipts.
An estimated $108.8 billion of user fees for 2003 are
credited directly to expenditure accounts, and are generally available for expenditure when they are collected,
without further action by the Congress. An estimated
$43.9 billion of user fees for 2003 are deposited in offsetting receipt accounts, and are available to be spent
only according to the legislation that established the
fees.
As a further classification, the accompanying Tables
5–2 and 5–3 identify the fees as discretionary or mandatory. These classifications are terms from the Budget
Enforcement Act of 1990 as amended and are used
frequently in the analysis of the budget. ‘‘Discretionary’’
in this chapter refers to fees generally controlled
through annual appropriations acts and under the jurisdiction of the appropriations committees in the Congress. These fees offset discretionary spending under
the discretionary caps. ‘‘Mandatory’’ refers to fees controlled by permanent laws and under the jurisdiction
of the authorizing committees. These fees are subject
to rules of paygo, whereby changes in law affecting
mandatory programs and receipts cannot result in a
net cost. Mandatory spending is sometimes referred to
as direct spending.
These and other classifications are discussed further
in this volume in Chapter 25, ‘‘Budget System and Concepts and Glossary.’’
II. Current User Fees
As shown in Table 5–2, total user fee collections (including those proposed in this budget) are estimated
to be $154.3 billion in 2003, increasing to $176.9 billion
in 2007. User fee collections by the Postal Service and
Medicare premiums are the largest and are estimated
to be almost two-thirds of total user fee collections in
2003.

86

ANALYTICAL PERSPECTIVES

Table 5–2.

TOTAL USER FEE COLLECTIONS
(In millions of dollars)
2001
Actual

Estimates
2002

2003

2004

2005

2006

2007

Receipts
Agricultural quarantine inspection fees ...................................................................................................
Corps of Engineers, Harbor maintenance fees ......................................................................................
Other governmental receipts user fees ..................................................................................................

265
722
545

215
733
515

260
823
532

259
839
538

266
909
548

272
972
552

279
1,005
559

Subtotal, receipts .................................................................................................................................

1,532

1,463

1,615

1,636

1,723

1,796

1,843

153
1,366
5,834

185
1,665
5,828

221
1,826
6,052

233
1,985
6,052

238
2,145
6,052

241
2,299
6,052

246
2,405
6,052

Offsetting Collections and Receipts from the Public
Discretionary
Department of Agriculture: Food safety inspection and other fees ..................................................
Department of Commerce: Patent and trademark, fees for weather services, and other fees ......
Department of Defense: Commissary and other fees .......................................................................
Department of Energy: Federal Energy Regulatory Commission, power marketing, and other
fees ..................................................................................................................................................
Department of Health and Human Services: Food and Drug Administration, Centers for Medicare and Medicaid Services, and other fees .................................................................................
Department of the Interior: Minerals Management Service and other fees .....................................
Department of Justice: Antitrust and other fees ................................................................................
Department of State: Passport and other fees ..................................................................................
Department of Transportation: Railroad safety, navigation, and other fees .....................................
Department of the Treasury: Sale of commemorative coins and other fees ...................................
Department of Veterans Affairs: Medical care and other fees .........................................................
Social Security Administration: State supplemental fees, supplemental security income ................
Federal Communications Commission: Regulatory fees ...................................................................
Federal Trade Commission: Regulatory fees .....................................................................................
Nuclear Regulatory Commission: Regulatory fees ............................................................................
Securities and Exchange Commission: Regulatory fees ...................................................................
All other agencies, discretionary user fees ........................................................................................

917

1,297

1,276

1,303

1,329

1,362

1,393

273
212
304
544
38
1,489
774
91
208
91
453
735
220

294
210
414
508
144
1,257
808
106
227
163
479
1,149
267

529
209
435
656
381
1,910
1,087
111
248
178
518
1,332
293

531
212
441
670
629
1,439
1,288
119
253
182
523
1,542
338

543
217
446
685
640
1,470
1,377
126
258
187
528
1,837
346

545
223
452
701
652
1,505
1,467
134
264
192
545
2,171
354

549
227
458
717
665
1,539
1,558
143
270
197
563
1,142
365

Subtotal, discretionary user fees ....................................................................................................

13,702

15,001

17,262

17,740

18,424

19,159

18,489

1,240
265

1,100
743

1,097
599

1,198
599

1,237
599

1,199
599

1,215
599

Mandatory
Department of Agriculture: Crop insurance and other fees ..............................................................
Department of Defense: Commissary surcharge and other fees ......................................................
Department of Energy: Proceeds from the sale of energy, nuclear waste disposal fees, and
other fees ........................................................................................................................................
Department of Health and Human Services: Medicare Part B insurance premiums and other
fees ..................................................................................................................................................
Department of the Interior: Recreation and other fees .....................................................................
Department of Justice: Immigration and other fees ..........................................................................
Department of Labor: Insurance premiums to guaranty private pensions ........................................
Department of the Treasury: Customs, bank regulation, and other fees .........................................
Department of Veterans Affairs: Veterans life insurance and other fees .........................................
Federal Emergency Management Agency: Flood insurance fees ....................................................
Office of Personnel Management: Federal employee health and life insurance fees .....................
Federal Communications Commission: Analog spectrum lease fee .................................................
Federal Deposit Insurance Corporation: Deposit insurance fees ......................................................
Postal Service: Fees for postal services ............................................................................................
Tennessee Valley Authority: Proceeds from the sale of energy .......................................................
All other agencies, mandatory user fees ...........................................................................................

4,851

4,623

4,508

4,650

4,295

4,246

4,237

23,764
634
1,821
850
1,929
1,553
1,603
7,404
..............
83
64,871
7,326
224

25,637
672
2,241
886
1,992
1,974
1,729
8,037
..............
86
67,794
7,348
322

27,363
626
2,320
829
2,143
2,114
1,785
9,881
..............
893
73,727
7,205
337

29,063
641
2,312
818
717
2,101
1,839
10,680
..............
2,123
75,796
7,462
372

31,082
643
2,352
830
736
2,059
1,906
11,372
..............
2,274
77,996
7,674
384

33,264
646
2,394
827
751
2,077
1,980
12,091
..............
2,333
79,996
7,806
397

35,568
649
2,438
823
766
2,035
2,069
12,886
500
2,375
81,996
8,018
405

Subtotal, mandatory user fees .......................................................................................................

118,418

125,184

135,427

140,371

145,439

150,606

156,579

Subtotal, offsetting collections and receipts from the public .............................................................

132,120

140,185

152,689

158,111

163,863

169,765

175,068

Total, User fees ......................................................................................................................................

133,652

141,648

154,304

159,747

165,586

171,561

176,911

User fee collections are used to offset outlays in both
the discretionary and mandatory parts of the budget.
User fee collections classified in the discretionary part

of the budget are estimated to be $17.3 billion in 2003,
and those in the mandatory part are estimated to be
$135.4 billion in 2003.

87

5. USER FEES AND OTHER COLLECTIONS

III.

User Fee Proposals

As shown in Table 5–3, the Administration is proposing new or increased user fees that would increase
collections by an estimated $1.5 billion in 2003, increasing to $2.9 billion in 2007.
A. User Fee Proposals to Offset Discretionary
Spending
1. Offsetting collections

authorized in 1992 and reauthorized in 1997, PDUFA
assesses user fees to pharmaceutical manufacturers for
the Food and Drug Administration (FDA) review of new
prescription drugs for safety and efficacy. FDA review
of a new prescription drug is required before these
drugs are available to consumers on the market. Spending financed by these fees would be in addition to regular appropriations.

Department of Agriculture

Department of State

Animal and Plant Health Inspection Service.—Legislation will be proposed to establish user fees for APHIS
costs for animal welfare inspections, such as for animal
research centers, humane societies, and kennels.
Grain Inspection, Packers and Stockyards Administration.—Legislation will be proposed to establish a fee
for the standardization activities of the Grain Inspection, Packers and Stockyards Administration, and a licensing fee to cover the costs of administering these
programs.

Machine readable visa fee.—The State Department
plans to increase machine readable visa (MRV) collection fees by more than 30 percent, from $45 to $65.
Since 1996, MRVs have been available at all 221 U.S.
visa issuing posts around the world. These visas provide increased border security control through the use
of biometric technology. MRVs currently include
digitized photographs and personal information related
to the traveler. However, they have the capability to
encode retinal images, fingerprints and other personal
details, which can then be read electronically and relayed to other Federal agencies to be compared to other
database information. Approximately 5 million visas are
processed annually.

Department of Commerce
Patent and Trademark Office.—The Administration
proposes changes to patent and trademark fee schedules effective in 2004 to fully support the PTO’s longterm objectives to reduce application processing times
and increase patent and trademark quality. As a first
step, the Administration is proposing a one-year surcharge on all patent and trademark fees in 2003 as
a proxy for the draft legislation.
International Trade Administration.—The Budget
proposes an increase in fee collections of $10 million
in 2003 and later years for ITA. In addition, ITA will
study different fee options in 2002 to determine an
appropriate model for cost recovery from firms that receive trade promotion services.
Department of Health and Human Services
User Fees for Medicare providers for paper claims
and duplicate or unprocessable claims.—The Administration is proposing new user fees for providers submitting paper claims and duplicate or unprocessable
claims. Under this proposal, providers would be charged
$1.50 for every paper claim submitted for payment. The
fee is necessary because processing paper claims is
more costly than processing electronic claims. Paper
claim fees would be waived for rural and poor providers.
The Centers for Medicare and Medicaid Services and
its contractors go to great lengths to ensure that providers are aware of billing requirements and the need
to submit accurate claims. Charging a fee for duplicate
or unprocessable claims would heighten provider awareness of these issues and increase efficiency by deterring
this action.
Fees for the review of new prescription drugs.—The
Administration is proposing the reauthorization of the
Prescription Drug User Fee Act (PDUFA). Originally

Commodity Futures Trading Commission
Fees on each round-turn commodities futures and options transactions.—The Commodities Futures Trading
Commission regulates U.S. futures and options markets. It strives to protect investors by preventing fraud
and abuse and ensuring adequate disclosure of information. The President’s Budget includes a fee on each
round-turn commodities futures and options transaction
that will be phased in during 2003. This proposal recognizes that market participants derive direct benefits
from CFTC’s oversight, which provides legal certainty
and contributes to the integrity and soundness of the
markets.
Federal Trade Commission
Do Not Call List fee.—The Federal Trade Commission
is proposing new fees that will be assessed, collected
and used to cover costs of developing, implementing
and maintaining a national database of telephone numbers of consumers who choose not to receive telephone
solicitations, as authorized by the Telephone Consumer
and Abuse Prevention Act.
2.

Offsetting receipts

Department of Transportation
Hazardous materials transportation safety fees.—Beginning in 2003, 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.
Appropriation language is proposed to increase the fees

88

ANALYTICAL PERSPECTIVES

Table 5–3.

USER FEE PROPOSALS

(Estimated collections in millions of dollars)
2003

DISCRETIONARY
1. Offsetting collections
Department of Agriculture
Animal Plant and Health Inspection Service ................................................................................................................
Grain Inspection, Packers, and Stockyards Administration .........................................................................................
Department of Commerce
Patent and Trademark Office: Increase current fees and raise fee rates ..................................................................
International Trade Administration: Increased fee revenues for export promotion .....................................................
Department of Health and Human Services
User fees for Medicare providers for paper claims and duplicate or unprocessable claims .....................................
Food and Drug Administration: Fees for the review of new prescription drugs ........................................................
Department of State
Machine readable visa fee ............................................................................................................................................
Commodity Futures Trading Commission
Fees on each round-turn commodities futures and options transactions ...................................................................
Federal Trade Commission
Do Not Call List fee ......................................................................................................................................................

2004

2005

2006

2007

2003–2007

5
29

5
29

5
29

5
29

5
29

25
145

............
10

136
10

79
10

40
10

40
10

295
50

130
272

130
272

130
272

130
272

130
272

650
1,360

139

144

150

155

161

749

33

70

73

78

83

337

3

3

3

3

3

15

6
59
165

25
120
330

25
122
336

25
124
342

25
127
349

106
552
1,522

250

............

............

............

............

250

363

381

400

420

441

2,005

2. Offsetting receipts
Department of Transportation
Hazardous materials transportation safety fees ...........................................................................................................
Railroad safety inspection fees .....................................................................................................................................
Coast Guard commercial navigation assistance fee ....................................................................................................
Department of the Treasury
Customs Service air/sea passenger fee and cruise vessel fee ..................................................................................
Department of Veterans Affairs
Implement $1,500 deductible for priority level 7 (non-disabled, higher income) veterans for health care ...............
Environmental Protection Agency
Abolish cap on pre-manufacturing notification fees .....................................................................................................
Nuclear Regulatory Commission
Extend NRC fees at their 2005 level for 2006 and later ............................................................................................

4

8

8

8

8

36

............

............

............

345

357

702

Subtotal, discretionary fee proposals .......................................................................................................................

1,468

1,663

1,642

1,986

2,040

8,799

MANDATORY
1. Offsetting collections
Federal Emergency Managment Agency
Flood insurance fees .....................................................................................................................................................

8

43

83

130

191

455

............
............
............

72
3
............

72
10
43

74
14
44

74
15
44

292
42
131

............

............

43

44

44

131

6

11

16

21

21

75

............

............

............

............

500

500

Subtotal, mandatory user fee proposals ..................................................................................................................

14

129

267

327

889

1,626

Total, user fee proposals .....................................................................................................................................

1,482

1,792

1,909

2,313

2,929

10,425

2. Offsetting receipts
Department of Agriculture
Food Safety and Inspection Service user fees ............................................................................................................
Forest Service ski fee permits ......................................................................................................................................
Forest Service recreation and entrance fees ...............................................................................................................
Department of the Interior
Recreation and entrance fees ......................................................................................................................................
Corps of Engineers
Recreation user fees .....................................................................................................................................................
Federal Communications Commission
Analog spectrum lease fee ..........................................................................................................................................

paid by shippers and carriers of hazardous materials
in 2003 to fund these safety activities.
Railroad safety inspection fee.—This proposal would
fund Federal Railroad Administration safety inspections
and the safety component of the railroad research and
development program. The fees would be collected from
the primary beneficiaries of these services, the railroad
carriers, and be based upon a calculation of their usage
as established through regulations. The estimated 2003
collections are 50 percent of the anticipated cost of safety services. In subsequent years these services would
be fully funded with user fees.

. Coast Guard commercial navigation assistance fee.—
This proposal would partially recover the costs of providing Coast Guard navigational assistance services.
The fees would be collected from the primary beneficiaries of these services, which are commercial cargo
and cruise vessels. The estimated 2003 collections assume a six month implementation period for this new
fee and represent 50 percent of the anticipated full
year receipts.

89

5. USER FEES AND OTHER COLLECTIONS

Department of the Treasury
Customs Service air/sea passenger fee and cruise vessel fee.—The Administration proposes an increase in
two of the user fees collected by the Customs Service.
The air/sea passenger fee was established in 1986 at
$5.00 per passenger. The cruise vessel passenger fee
was established at $1.75 per passenger. The receipts
from these fees are used to pay for Customs’ overtime
inspections and related expenses. The air/sea fee would
increase to $11 per passenger. The cruise vessel fee
would increase to $2 per passenger. The new fee levels
would help to offset higher costs incurred by the Customs Service.
Department of Veterans Affairs
Implement a $1,500 deductible for priority level 7 veterans for health care.—The budget request includes a
proposal to establish a $1,500 annual deductible for
priority level 7 veterans (non-disabled, higher-income).
This proposal is in response to the significant growth
in enrollment and usage by priority level 7 veterans
over the last 3 years, as well as anticipated future
growth. The objective is to have these veterans pay
a larger portion of the cost of their health care. Coupled
with the recent increase in pharmacy copayments and
decrease in outpatient care copayments, this proposal
makes certain that VA’s health care system is able
to continue providing high-quality health care to its
core population—disabled and low-income veterans.
Environmental Protection Agency
Abolish cap on pre-manufacturing notification fees.—
EPA collects fees from chemical manufacturers seeking
to bring new chemicals into commerce. These fees are
authorized by the Toxic Substances Control Act and
are now subject to an outdated statutory cap. The Administration is proposing appropriations language to
modify the cap so that EPA can increase fees to fully
cover the cost of the program.
Nuclear Regulatory Commission
Extend NRC fees at their 2005 level for 2006 and
later.—The Omnibus Budget Reconciliation Act (OBRA)
of 1990, as amended, required that the Nuclear Regulatory Commission (NRC) assess license and annual
fees that recover approximately 94 percent of its budget
authority in 2003, less the appropriation from the Nuclear Waste Fund. Licensees are required to reimburse
NRC for its services, because licensees benefit from
such services.
Under OBRA, as amended, the budget authority recovery requirement decreases by 2 percentage points
per year until it reaches 90 percent in 2005. After 2005,
the requirement reverts to 33 percent per year. If the
90 percent requirement is not extended beyond 2005,
fees would drop from an estimated $528 million in 2005
to $200 million in 2006; with an extension at 90 percent, fees would be an estimated $545 million in 2006,
an increase of $345 million.

B. User Fee
Spending
1.

Proposals

to

Offset

Mandatory

Offsetting collections

Federal Emergency Management Agency
Flood insurance fees.—The Administration proposes
to phase out subsidized premiums for flood insurance
for vacation homes, rental properties, and other nonprimary residences. Insurance rates for primary residences, which represent the majority of the program’s
policies, would not change under these proposal. In addition, the Administration proposes to include the cost
of expected erosion losses for flood insurance policies
in coastal areas, require that mortgage borrowers insure the full replacement value of their properties, and
end State taxation of flood insurance polices.
2. Offsetting receipts
Department of Agriculture
Food Safety and Inspection Service.—Legislation will
be proposed replacing the existing overtime fee structure with a revised structure that would distribute fees
more proportionately between large and small plants.
Overtime fees would also apply to all inspection hours
provided after one eight hour shift. However, since the
goal of the proposed fee is equity, rather than revenue,
the costs for the overtime would be shared with the
Federal Government paying 50 percent of the total
overtime costs.
In addition to overtime fees, the legislative proposal
would recover some overhead costs by charging all
plants an annual fee in direct proportion to the plants
volume of output. The funds collected would be available without appropriation to cover food safety-related
activities and research.
Forest Service ski fees permits.—This proposal would
require the receipt of fair market value from use and
occupancy of ski resorts on national forest lands. The
proposal would amend the Omnibus Parks and Public
Lands Management Act (P.L. 104–333), which established a new fee schedule for ski resorts on National
Forest System lands. The amendment would adjust percentages of gross revenue that determine fees to the
Government. Funds collected are available for forest
restoration of landscapes impacted by ski resorts.
Forest Service recreation and entrance fees.—The Administration proposes to permanently extend the current pilot program that allows the Forest Service to
collect increased recreation and entrance fees. These
receipts would be available for use without further appropriation and are necessary to maintain and improve
recreation facilities and services. A similar proposal affects recreation fees for the National Park Service, the
Bureau of Land Management, and the Fish and Wildlife
Service in the Department of the Interior.
Department of the Interior
Recreation and entrance fees.—The Administration
proposes to extend permanently the current recreation
fee demonstration program. Since 1996, this program

90

ANALYTICAL PERSPECTIVES

has allowed the National Park Service, the Bureau of
Land Management, and the Fish and Wildlife Service
to collect increased recreation and entrance fees and
spend the receipts without further appropriation on facility improvements, visitor programs, and other services. At least half of the National Park Service receipts
will be used to address deferred maintenance needs.
A related proposal affects recreation fees for the Forest
Service in the Department of Agriculture.
Corps of Engineers
Recreation user fees.—The Administration proposes to
phase in recreation user fee increases with the entire
increase available without further legislative action for
spending on operation, maintenance, and improvements
of the recreation facilities of the Corps of Engineers,
many of which are obsolete. Legislation will be required
to increase limits on existing recreation user fees, au-

thorize new fees, or reclassify existing fees. In addition,
the Administration recommends extending the recreation demonstration program, which makes available
to the Corps without further appropriation recreation
fee revenues above a baseline of $34 million per year,
to be used for operation and maintenance of its recreation facilities. The Corps spends about $250 million
annually on these activities.
Federal Communications Commission
Analog spectrum lease fee.—The Administration proposes authorizing the FCC to establish an annual lease
fee totaling $500 million for the use of analog spectrum
by commercial broadcasters beginning in 2007, to facilitate the clearing of analog television broadcast spectrum and provide taxpayers some compensation for use
of this scarce resource.

OTHER OFFSETTING COLLECTIONS AND RECEIPTS
Table 5–4 shows that total offsetting collections and
receipts from the public are estimated to be $231.2
billion in 2003. Of these, an estimated $149.3 billion
are offsetting collections credited to appropriation accounts and an estimated $81.9 billion are deposited
in offsetting receipt accounts.
The user fees in Table 5–4 were discussed in the
previous section. Major offsetting collections deposited
in expenditure accounts that are not user fees are precredit reform loan repayments, collections from States
to supplement payments in the supplemental security
income program, and collections for the Federal Savings
and Loan resolution fund. Major offsetting receipts that
are not user fees include spectrum auction receipts,
military assistance program sales, rents and royalties
for oil and gas on the Outer Continental Shelf, and
interest income.

Table 5–5 includes all offsetting receipts deposited
in receipt accounts. These include payments from one
part of the Government to another, called
intragovernmental transactions, and collections from
the public. These receipts are offset (deducted) from
outlays in the Federal budget. In total, offsetting receipts are estimated to be $511.5 billion in 2003—
$429.6 billion are intragovernmental transactions, and
$81.9 billion are from the public, shown in the table
as proprietary receipts from the public and offsetting
governmental receipts.
As noted above, offsetting collections and receipts by
agency are also displayed in Table 21–1, ‘‘Outlays to
the Public, Net and Gross,’’ which appears in Chapter
21 of this volume.

91

5. USER FEES AND OTHER COLLECTIONS

Table 5–4.

OFFSETTING COLLECTIONS AND RECEIPTS FROM THE PUBLIC
(In millions of dollars)
2001
Actual

Estimate
2002

2003

Offsetting collections credited to expenditure accounts:
User fees:
Postal service stamps and other postal fees .........................................................................................................................................
Defense Commissary Agency .................................................................................................................................................................
Employee contributions for employees and retired employees health benefits funds 1 ........................................................................
Sale of energy:
Tennessee Valley Authority .................................................................................................................................................................
Bonneville Power Administration .........................................................................................................................................................
All other user fees ...................................................................................................................................................................................

64,871
5,083
5,855

67,794
73,727
5,101
5,351
6,503 ......................

7,326
3,937
14,880

7,348
3,697
16,942

7,205
3,616
18,871

Subtotal, user fees ..............................................................................................................................................................................
Other collections credited to expenditure accounts:
Pre-credit reform loan repayments ..........................................................................................................................................................
Supplemental security income (collections from the States) .................................................................................................................
Federal Savings and Loan Insurance Corporation resolution fund .......................................................................................................
Other collections ......................................................................................................................................................................................

101,952

107,385

108,770

14,078
3,160
1,688
19,386

14,851
3,797
1,243
20,082

13,551
3,937
267
22,786

Subtotal, other collections ...................................................................................................................................................................

38,312

39,973

40,541

Subtotal, offsetting collections credited to expenditure accounts ..........................................................................................................

140,264

147,358

149,311

User fees:
Medicare premiums ..................................................................................................................................................................................
23,748
25,622
Employee contributions for employees and retired employees health benefits funds 1 ........................................................................ ...................... ......................
All other user fees ..................................................................................................................................................................................
6,420
7,178

27,347
8,264
8,308

Offsetting receipts:

Subtotal, user fees deposited in receipt accounts .............................................................................................................................
Other collections deposited in receipt accounts:
Spectrum auction receipts ......................................................................................................................................................................
Military assistance program sales ..........................................................................................................................................................
OCS rents, bonuses, and royalties ........................................................................................................................................................
Interest income .......................................................................................................................................................................................
All other collections deposited in receipt accounts ...............................................................................................................................

30,168

32,800

43,919

1,024
10,229
7,194
12,175
19,497

530
10,300
3,806
12,513
16,086

460
10,410
2,832
13,887
10,402

Subtotal, other collections deposited in receipt accounts ..............................................................................................................................

50,119

43,235

37,991

Subtotal, collections deposited in receipt accounts ...................................................................................................................................

80,287

76,035

81,910

Total, offsetting collections and receipts from the public .......................................................................................................................

220,551

223,393

231,221

Total, offsetting collections and receipts excluding off-budget ..............................................................................................................

155,554

155,454

157,344

ADDENDUM:
User fees that are offsetting collections and receipts 2 .................................................................................................................................
Other offsetting collections and receipts from the public ..............................................................................................................................

132,120
88,431

140,185
83,208

152,689
78,532

Total, offsetting collections and receipts from the public ......................................................................................................................

220,551

223,393

231,221

1 Beginning

in 2003, amounts received by the Federal Employees Health Benefits Program (FEHBP), previously treated as offsetting collections, are now treated as offsetting receipts. This reflects a change in the FEHBP from a trust revolving fund to a special fund and is consistent with the President’s proposed Managerial Flexibility Act.
2 Excludes user fees that are classified on the receipts side of the budget. For total user fees, see Table 5.1 or Table 5.2.

92

ANALYTICAL PERSPECTIVES

Table 5–5. OFFSETTING RECEIPTS BY TYPE
(In millions of dollars)

Source
INTRAGOVERNMENTAL TRANSACTIONS
On-budget receipts:
Federal intrafund transactions:
Distributed by agency:
Interest from the Federal Financing Bank ...................................................................
Interest on Government capital in enterprises ............................................................
Interest received by retirement and health benefits funds .........................................
General fund payments to retirement and health benefits funds:
Employees health benefits fund ..............................................................................
DoD retiree health care fund ...................................................................................
Miscellaneous Federal retirement funds 1 ...............................................................
Subsidy balance transfers ............................................................................................
Other .............................................................................................................................
Undistributed by agency:
Employing agency contributions:
Employees health benefits fund ..............................................................................
DoD retiree health care fund ...................................................................................
Miscellaneous Federal retirement funds ..................................................................

2001
Actual

Estimate
2002

2,157
1,930
1,091
1,095
.................. ..................

2003

1,484
1,075
773

2004

1,724
1,047
1,335

2005

2,044
1,165
1,899

2006

2,342
932
2,491

2007

2,230
826
3,112

.................. ..................
11,622
11,026
11,026
11,026
11,026
.................. ..................
16,351
24,455
27,034
29,816
32,817
.................. ..................
888
893
902
912
923
4,026
909 .................. .................. .................. .................. ..................
3,323
2,403
2,475
2,538
2,661
2,779
2,896
.................. ..................
.................. ..................
8,219
8,683

16,404
8,312
279

17,475
15,475
331

18,587
16,416
288

19,800
17,418
285

21,168
18,500
286

Total Federal intrafunds ................................................................................................

18,816

15,020

59,663

76,299

82,022

87,801

93,784

Trust intrafund transactions:
Distributed by agency:
Payments to railroad retirement ...................................................................................
Other .............................................................................................................................

3,283
1

3,863
1

3,854
1

3,807
1

3,808
1

3,658
1

3,911
1

Total trust intrafunds .....................................................................................................

3,284

3,864

3,855

3,808

3,809

3,659

3,912

Total intrafund transactions ..............................................................................................

22,100

18,884

63,518

80,107

85,831

91,460

97,696

Interfund transactions:
Distributed by agency:
Federal fund payments to trust funds:
Contributions to insurance programs:
Military retirement fund ........................................................................................
16,089
17,047
Supplementary medical insurance .......................................................................
69,838
77,295
Proposed Legislation (non-PAYGO) .................................................................... .................. ..................
Hospital insurance ................................................................................................
5,594
11,544
Railroad social security equivalent fund .............................................................
98
95
Rail industry pension fund ...................................................................................
229
242
Civilian supplementary retirement contributions ..................................................
21,890
22,399
Unemployment insurance ....................................................................................
432
517
Other contributions ...............................................................................................
560
482

17,643
80,905
–19
9,423
100
254
29,660
531
506

18,261
84,790
–1
9,807
103
265
29,666
526
508

18,900
90,003
102
10,385
106
275
29,669
522
535

19,563
96,284
74
10,963
109
284
29,672
526
533

20,247
103,019
54
11,657
114
296
29,674
541
536

139,003

143,925

150,497

158,008

166,138

Subtotal ................................................................................................................

114,730

129,621

Miscellaneous payments ..........................................................................................
1,520
930
Proposed Legislation (non-PAYGO) ........................................................................ .................. ..................
Subtotal .....................................................................................................................

116,250

130,551

988
944
901
882
865
2,066 .................. .................. .................. ..................
142,057

144,869

151,398

158,890

167,003

Trust fund payments to Federal funds:
Quinquennial adjustment for military service credits ..............................................
836 .................. .................. .................. .................. .................. ..................
Other .........................................................................................................................
2,301
1,141
1,171
1,193
1,217
1,242
1,278
Proposed Legislation (non-PAYGO) ........................................................................ .................. ..................
1,606
–446
–435
–430
–427
Subtotal .....................................................................................................................

3,137

1,141

2,777

747

782

812

851

Total interfunds distributed by agency .........................................................................

119,387

131,692

144,834

145,616

152,180

159,702

167,854

Undistributed by agency:
Employer share, employee retirement (on-budget):
Civil service retirement and disability insurance .....................................................
CSRDI from Postal Service .....................................................................................
Hospital insurance (contribution as employer) 2 .....................................................
Postal employer contributions to FHI ......................................................................
Military retirement fund .............................................................................................

10,072
6,600
2,031
673
11,371

10,612
6,780
2,183
711
12,491

14,233
6,932
2,299
733
11,934

14,599
7,089
2,402
756
12,396

14,956
7,320
2,538
781
12,911

15,239
7,555
2,645
808
13,383

15,475
7,745
2,755
836
13,847

93

5. USER FEES AND OTHER COLLECTIONS

Table 5–5. OFFSETTING RECEIPTS BY TYPE—Continued
(In millions of dollars)

Source

2001
Actual

Estimate
2002

2003

2004

2005

2006

2007

Other Federal employees retirement .......................................................................

136

134

138

142

147

152

157

Total employer share, employee retirement (on-budget) ........................................

30,883

32,911

36,269

37,384

38,653

39,782

40,815

Interest received by on-budget trust funds .............................................................
75,302
74,287
Proposed Legislation (non-PAYGO) ........................................................................ .................. ..................

77,254
–9

80,145
–44

83,559
–93

87,259
–149

91,793
–204

Total interfund transactions undistributed by agency ..................................................

106,185

107,198

113,514

117,485

122,119

126,892

132,404

Total interfund transactions ..............................................................................................

225,572

238,890

258,348

263,101

274,299

286,594

300,258

Total on-budget receipts .......................................................................................................

247,672

257,774

321,866

343,208

360,130

378,054

397,954

12,528

13,478

14,282

15,149

16,041

16,841

17,990

7,910
68,811

9,243
76,822

9,564
83,849

10,232
92,029

11,034
101,015

11,744
110,959

12,448
122,109

Total off-budget receipts: ......................................................................................................

89,249

99,543

107,695

117,410

128,090

139,544

152,547

Total intragovernmental transactions ...................................................................................

336,921

357,317

429,561

460,618

488,220

517,598

550,501

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) 3 ......................................................................................

576
951
10,647

651
451
11,411

639
585
12,663

633
585
13,283

625
585
13,770

608
585
14,238

632
585
14,659

Total interest ......................................................................................................................

12,174

12,513

13,887

14,501

14,980

15,431

15,876

Off-budget receipts:
Trust intrafund transactions:
Distributed by agency:
Interfund transactions:
Distributed by agency:
Federal fund payments to trust funds:
Old-age, survivors, and disability insurance ............................................................
Undistributed by agency:
Employer share, employee retirement (off-budget) .................................................
Interest received by off-budget trust funds .............................................................

Dividends and other earnings ........................................................................................... .................. .................. .................. .................. .................. .................. ..................
Royalties and rents ...............................................................................................................
2,235
1,458
1,494
1,551
1,526
1,604
1,635
Sale of products:
Sale of timber and other natural land products ...............................................................
218
623
635
400
407
397
387
Proposed Legislation (PAYGO) ........................................................................................ .................. .................. ..................
3
10
14
15
Sale of minerals and mineral products ............................................................................
31
27
30
33
32
32
30
Sale of power and other utilities ......................................................................................
562
721
683
695
695
714
717
Proposed Legislation (PAYGO) ........................................................................................ .................. ..................
–149
–149
–150
–150
–150
Other 3 ...............................................................................................................................
73
89
77
77
77
77
77
Total sale of products .......................................................................................................

884

1,460

1,276

1,059

1,071

1,084

1,076

Fees and other charges for services and special benefits:
Medicare premiums and other charges (trust funds) ......................................................
23,748
25,622
27,347
Proposed Legislation (PAYGO) ........................................................................................ .................. .................. ..................
Employees health benefits premiums .............................................................................. .................. ..................
8,352
Nuclear waste disposal revenues .....................................................................................
689
640
647
Veterans life insurance (trust funds) ................................................................................
194
198
184
Other 3 ...............................................................................................................................
2,409
3,124
3,480
Proposed Legislation (PAYGO) ........................................................................................ .................. ..................
6

29,013
35
9,077
612
170
3,780
93

30,984
82
9,717
637
154
3,808
189

33,152
95
10,380
621
139
3,990
207

35,529
23
11,121
609
125
4,133
208

Total fees and other charges ...........................................................................................

27,040

29,584

40,016

42,780

45,571

48,584

51,748

Sale of Government property:
Sale of land and other real property 3 .............................................................................
Military assistance program sales (trust funds) ...............................................................
Other ..................................................................................................................................

86
10,229
358

150
10,300
759

412
10,410
90

110
10,380
65

110
10,570
66

110
10,730
41

107
10,890
7

Total sale of Government property ..................................................................................

10,673

11,209

10,912

10,555

10,746

10,881

11,004

94

ANALYTICAL PERSPECTIVES

Table 5–5. OFFSETTING RECEIPTS BY TYPE—Continued
(In millions of dollars)

Estimate

2001
Actual

Source

2002

2003

2004

2005

2006

2007

Realization upon loans and investments:
Negative subsidies and downward reestimates ...............................................................
Repayment of loans to foreign nations ............................................................................
Other ..................................................................................................................................

8,627
291
83

6,027
71
117

751
85
97

757
88
93

764
94
89

773
108
85

748
25
83

Total realization upon loans and investments .................................................................

9,001

6,215

933

938

947

966

856

Recoveries and refunds 3 ......................................................................................................
3,730
2,780
Proposed Legislation (PAYGO) ............................................................................................ .................. ..................
Miscellaneous receipt accounts 3 ..........................................................................................
2,293
1,909

2,882
7
1,916

3,011
14
1,924

3,119
–103
1,928

3,201
–164
1,941

3,305
–172
1,945

73,323

76,333

79,785

83,528

87,273

Total proprietary receipts from the public distributed by agency ........................................

68,030

67,128

Undistributed by agency:
Other interest: Interest received from Outer Continental Shelf escrow account ................
1 .................. .................. .................. .................. .................. ..................
Rents, bonuses, and royalties:
Outer Continental Shelf rents and bonuses .....................................................................
719
834
466
509
427
396
347
Outer Continental Shelf royalties ......................................................................................
6,475
2,972
2,366
2,443
3,243
3,573
3,671
Arctic National Wildlife Refuge:
Proposed Legislation (PAYGO) ........................................................................................ .................. .................. ..................
2,402
2
202
2
Sale of major assets ............................................................................................................. .................. .................. .................. ..................
323 .................. ..................
Total proprietary receipts from the public undistributed by agency ....................................

7,195

3,806

2,832

5,354

3,995

4,171

4,020

Total proprietary receipts from the public 4 ........................................................................

75,225

70,934

76,155

81,687

83,780

87,699

91,293

4,739
313
243

3,015
128
409

3,056
130
416

3,111
132
423

3,168
135
431

4,510
–4,050

10,565
3,350

8,770
2,700

675
4,700

680
500

OFFSETTING GOVERNMENTAL RECEIPTS
Distributed by agency:
Regulatory fees 3 ...................................................................................................................
3,964
4,494
Proposed Legislation (non-PAYGO) ..................................................................................... .................. ..................
Other ......................................................................................................................................
74
77
Undistributed by agency:
Spectrum auction proceeds ..................................................................................................
1,024
530
Proposed Legislation (PAYGO) ............................................................................................ .................. ..................
Total offsetting governmental receipts ..................................................................................

5,062

5,101

5,755

17,467

15,072

9,041

4,914

Total offsetting receipts ..........................................................................................................

417,208

433,352

511,471

559,772

587,072

614,338

646,708

1 2001

and 2002 amounts are offsets for the Administration’s retirement acrual proposal.
2 Includes provision for covered Federal civilian employees and military personnel.
3 Includes both Federal funds and trust funds.
4 Consists of:
MEMORANDUM
Composition of proprietary receipts from the public

2001
Actual
On-budget:
Federal funds ..................................
Trust funds ......................................
Off-budget ............................................

39,952
35,190
83

Estimate
2002

2003

2004

2005

2006

2007

33,366
37,489
79

36,428
39,646
81

40,180
41,423
84

40,076
43,618
86

41,639
45,972
88

42,775
48,427
91

6. TAX EXPENDITURES
The Congressional Budget Act of 1974 (Public Law
93–344) requires that a list of ‘‘tax expenditures’’ be
included in the budget. Tax expenditures are defined
in the law as ‘‘revenue losses attributable to provisions
of the Federal tax laws which allow a special exclusion,
exemption, or deduction from gross income or which
provide a special credit, a preferential rate of tax, or
a deferral of liability.’’ The Act suggests that tax expenditures are exceptions to some norm or standard
tax concept that is not specified in the law. Hence,
different analyses may use different baseline tax structures; indeed, the budget presentation here provides
tax expenditure estimates measured against more than
one baseline.
Due, in part, to the degree of arbitrariness in the
tax expenditure baseline, the Administration believes
the meaningfulness of tax expenditure estimates is uncertain and that the ‘‘tax expenditure’’ presentation can
be improved by consideration of alternative or additional tax bases. A description of an ongoing Treasury
study to reevaluate the tax expenditure concept is presented at the beginning of this chapter. The tax expenditure estimates and related discussion following the description of this study, however, are based on materials
and formats developed and included in previous budgets. Tax expenditure estimates under the unified transfer (i.e., estate and gift) tax have been eliminated from
the presentation because there is no generally accepted
normal baseline for transfer taxes and this tax has
been repealed under the Economic Growth and Tax
Relief Reconciliation Act of 2001 (EGTRRA).
The largest reported tax expenditures tend to be associated with the individual income tax. For example,
sizeable deferrals, deductions and exclusions 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. Reported tax expenditures under the
corporate income tax tend to be related to timing differences in 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.
Each tax expenditure estimate in this chapter was
calculated assuming other parts of the tax code remained unchanged. The estimates would be different
if all tax expenditures or major groups of tax expenditures were changed simultaneously because of potential
interactions among provisions. For that reason, this
chapter does not present a grand total for the estimated
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.
Tax expenditures relating to the individual and corporate income taxes are estimated for fiscal years
2001–2007 using three methods of accounting: revenue
effects, outlay equivalent, and present value. The
present value approach provides estimates of the revenue effects for tax expenditures that involve deferrals
of tax payments into the future or have similar longterm effects.
The section of the chapter on performance measures
and economic effects presents information related to
assessment of the effect of tax expenditures on the
achievement of program performance goals. This section
is a complement to the government-wide performance
plan required by the Government Performance and Results Act of 1993.

FUTURE REVISIONS TO THE TAX EXPENDITURE PRESENTATION
Policymakers and researchers have long recognized
that certain income tax code provisions have policy purposes other than simply raising revenue and that it
is useful to understand better the nature of these provisions. It is important to know the amounts of revenue
associated with them, whether they are achieving desired results, and their consequences for the economy.
The answers to these questions are important simply
as a source of information, but also so that policymakers and the public can review these features of
the income tax regularly to see if change is warranted.
Thus it was that in 1974 the Congress mandated as
part of the Congressional Budget Act of 1974 that the
annual Federal budget presentation include a list of

‘‘tax expenditures’’, where tax expenditures were defined as:
...those revenue losses attributable to provisions
of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income
or which provide a special credit, a preferential
rate of tax, or a deferral of tax liability....
Though imperfect, the tax expenditure budget has
expanded our understanding of policy programs operating through the Federal income tax and, more generally, the workings of the Federal income tax.
The complexity of our economy and society on the
one hand, and the complexity of the income tax on
the other, suggest the need for a variety of analyses

95

96

ANALYTICAL PERSPECTIVES

to understand their interaction better. The Treasury
Department has begun an effort to review the tax expenditure presentation, and will be considering possible
revisions and improvements in methodology and approach. The need for this effort was raised in the President’s Fiscal Year 2002 budget submission, which noted
that the current tax expenditure analysis was developed relative to an arbitrary tax base and that:
Because of the breadth of this arbitrary tax base,
the Administration believes that the concept of
‘‘tax expenditure’’ is of questionable analytic
value. 1
This review is intended to improve the quality and
range of information available regarding the Federal
income tax and its effects on the economy. The Treasury Department’s efforts in this area will continue over
the coming year, assisted by public debate and comment.
The Need for Change
The definition of the baseline against which tax expenditures are measured is crucial to the definition and
calculation of tax expenditures. For purposes of calculating tax expenditures, the 1974 Budget Act did not
specify the provisions of the baseline tax law, which,
quoting further from the Fiscal Year 2002 budget,
means that: ‘‘Deciding whether provisions are exceptions (from the normal baseline), therefore, is a matter
of judgement.’’ As the normal baseline and deviations
from the baseline are constructed from a set of potentially subjective judgements, differences of opinion can
arise as to the correct classification of specific provisions of the tax code. While the normal baseline follows
a theoretically appealing measure of a comprehensive
income tax in many ways, it deviates in other important ways. These deviations may reflect judgements
along a number of dimensions, including administrative
concerns, political judgements, social policy, and historical methods of taxing income. But these deviations
inject a degree of subjectivity that can limit the value
of the underlying analysis.
One problem with injecting subjective elements into
the definition of the baseline income tax is that common
notions of what constitutes a ‘‘normal’’ income tax will
change over time. For example, although the tax exemption for employer-provided pensions is labeled a tax
expenditure, the growing presence of tax-deferred savings vehicles in the tax code suggests that these may
today be part of ‘‘normal’’ income tax circa 2002. It
is not clear, however, whether the ‘‘normal’’ income tax
of 2002 is more appropriate than that in place in any
other year if one is interested in better understanding
deviations of the current income tax from a more objective standard of a comprehensive income tax.
A highly subjective baseline also may not inform policymakers and the public about those aspects of social
or economic policy that are implemented through the
tax code. The Federal income tax contains many provisions for providing income support for lower-income citi1 Analytical

Perspectives, Budget of the United States, Fiscal Year 2002, Chapter 5.

zens. Examples include the Earned Income Tax Credit,
the Work Opportunity Credit, and the Child Tax Credit.
Each of these provisions is appropriately labeled a tax
expenditure in the current tax expenditure presentation. The personal exemption, which cannot be
claimed by higher-income taxpayers because of a phaseout of the exemption, however, is not presently labeled
a tax expenditure although it can also be viewed as
a component of the income support policies effected
through the income tax. In many other ways, the ‘‘normal tax’’ baseline may fail to capture the extent to
which the tax system serves such programmatic purposes.
Finally, the public and policymakers are interested
in the tax subsidies and excises imbedded in the tax
code and their effects on individual behavior and on
economic activity. Tax subsidies and excises arise when
the relative prices of goods, services, or activities are
distorted by the tax system. A highly subjective ‘‘normal
tax’’ may shed little light on these issues.
Because of the controversy that accompanies the existing ‘‘normal tax’’ concept, it may be appropriate to
reconsider a comprehensive income tax as a baseline
for the tax expenditure budget. Comprehensive income
is a well-accepted theoretical concept, and so avoids
some subjectivity that plagues the ‘‘normal tax’’ baseline. A comprehensive measure of income, however,
would not eliminate all contentious issues. Any practical implementation of a comprehensive tax base would
involve judgements, e.g., about which items of theoretical income or expense are too abstract or difficult
to estimate to include in the baseline, but that other
analysts may see as necessary.
Focus of the Reconsideration and Revision
Effort
The effort to improve the tax expenditure presentation will focus on three aspects. The first relates to
the definition of an income tax or standard against
which tax expenditures are identified and measured
as discussed above. The study will consider redefining
the baseline income concept to be more consistent with
a comprehensive income tax base, as well as other alternative definitions of income.
The study will also consider issues involved in estimating ‘‘negative’’ tax expenditures in addition to the
conventional positive tax expenditures currently reported in the Budget. A negative tax expenditure arises
whenever a tax provision causes a taxpayer to pay more
tax than would be consistent with the baseline income
tax. Negative tax expenditures have not been identified
and calculated in the past, in part because they did
not appear to relate to the original purpose of the tax
expenditure analysis to identify implicit spending programs operating through the tax system. Nevertheless,
negative tax expenditures provide an important additional perspective and may offer a useful source of information to analysts and policy makers.
Academics and tax specialists have studied intensively whether the United States should adopt a con-

97

6. TAX EXPENDITURES

sumption tax at the Federal level, either as a source
of additional revenue, or in place of some or all of
the current sources of Federal revenue. Though the existing Federal individual income tax is thought of as
a tax on income, in many respects it has evolved into
a hybrid tax containing some elements consistent both
with a comprehensive income tax and a consumption
tax, as well as many elements consistent with neither
an income nor a consumption tax. Therefore, the third
aspect of the Treasury’s effort will be to consider estimating tax expenditures relative to a hypothetical consumption tax, as well as relative to an income tax.
This would allow a comparison of the Federal income
tax vis-à-vis the two baseline systems. It would also
serve to give additional perspective on the tax expenditure analysis by highlighting those provisions in the
Federal income tax that may give rise to a tax expenditure or negative expenditure in one system but not
in the other.
When completed, this review can significantly improve the overall understanding of the effects of the

Federal income tax on the economy. For example, reconsideration of the income tax baseline is intended to
provide a baseline definition that can better capture
the numerous ways in which the tax system influences
economic behavior relative to a comprehensive income
tax system. Similarly, the definition and calculation of
negative tax expenditures can provide useful new information about those activities subject to a tax surcharge
relative to the baseline tax. Viewing these negative tax
expenditures alongside the traditional tax expenditure
presentation can provide important context for the overall tax expenditure budget. The calculation of tax expenditures and negative tax expenditures relative to
a consumption tax budget can provide further context
for the traditional tax expenditure presentation while
providing important new information about the effects
of the tax system on the economy. Finally, a consumption tax base analysis can help illuminate some of the
central issues that would arise in any effort to enact
a Federal consumption tax.

TAX EXPENDITURES IN THE INCOME TAX
Tax Expenditure Estimates
All tax expenditure estimates presented here are
based upon current tax law enacted as of December
31, 2001. Expired or repealed provisions are not listed
if their revenue effects result only from taxpayer activity occurring before fiscal year 2001. 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 effects for tax expenditures for fiscal years 2001–2007 are displayed according to the
budget’s functional categories in Table 6–1. Descriptions of the specific tax expenditure provisions follow
the tables of estimates and the 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 effects for these items are zero using the reference tax rules. The alternative baseline concepts are
discussed in detail following the tables.
Table 6–2 reports the respective portions of the total
revenue effects that arise under the individual and corporate income taxes separately. The location of the 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 breakdowns show the specific tax accounts through which

the various provisions are cleared. The ultimate beneficiaries of corporate tax expenditures could be shareholders, employees, customers, or other providers of
capital, depending on economic forces.
Table 6–3 ranks the major tax expenditures by the
size of their FY 2003 revenue effect.
Interpreting Tax Expenditure Estimates
The estimates shown for individual tax expenditures
in Tables 6–1, 6–2, and 6–3 do not necessarily equal
the increase in Federal revenues (or the change in the
budget balance) that would result from repealing these
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 activity or
of other tax provisions 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. Such indirect effects
are not reflected in the estimates.
Tax expenditures are interdependent even without
incentive effects. Repeal of a tax expenditure provision
can increase or decrease the tax revenues associated
with other provisions. For example, even if behavior
does not change, repeal of an itemized deduction could
increase the revenue costs from other deductions because some taxpayers would be moved into higher tax
brackets. Alternatively, repeal of an itemized deduction
could lower the revenue cost 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, because each is estimated assum-

98
ing that the other remains in force. In addition, the
estimates reported in Table 6–1 are the totals of individual and corporate income tax revenue effects reported in Table 6–2 and do not reflect any possible
interactions between the individual and corporate income tax receipts. For this reason, the estimates in
Table 6–1 (as well as those in Table 6–5, which are
also based on summing individual and corporate estimates) should be regarded as approximations.
The annual value of tax expenditures for tax deferrals is reported on a cash basis in all tables except
Table 6–4. 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. Although 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 effect on receipts to the Government because

ANALYTICAL PERSPECTIVES

the newly deferred taxes will ultimately be received.
Present-value estimates, which are a useful complement to the cash-basis estimates for provisions involving deferrals, are discussed below.
Present-Value Estimates
Discounted present-value estimates of revenue effects
are presented in Table 6–4 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
effects, net of future tax payments, that follow from
activities undertaken during calendar year 2001 that
cause the deferrals or other long-term revenue effects.
For instance, a pension contribution in 2001 would
cause a deferral of tax payments on wages in 2001
and on pension earnings on this contribution (e.g., interest) in later years. In some future year, however,
the 2001 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.

99

6. TAX EXPENDITURES

Table 6–1.

ESTIMATES OF TOTAL INCOME TAX EXPENDITURES
(In millions of dollars)
Total from corporations and individuals
2001

2002

2003

2004

2005

2006

2007

2003–2007

1

National Defense
Exclusion of benefits and allowances to armed forces personnel .......................................................

2,160

2,190

2,210

2,240

2,260

2,290

2,310

11,310

2
3
4
5
6
7

International affairs:
Exclusion of income earned abroad by U.S. citizens ...........................................................................
Exclusion of certain allowances for Federal employees abroad ..........................................................
Extraterritorial income exclusion .............................................................................................................
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 ................................................

2,450
760
4,490
1,400
6,600
1,300

2,540
800
4,820
1,470
7,000
550

2,660
840
5,150
1,540
7,450
0

2,690
880
5,510
1,620
7,900
0

2,760
920
5,890
1,700
8,400
0

2,810
960
6,290
1,790
8,930
0

3,170
1,020
6,730
1,880
9,550
0

14,090
4,620
29,570
8,530
42,230
0

8
9

General science, space, and technology:
Expensing of research and experimentation expenditures (normal tax method) .................................
Credit for increasing research activities .................................................................................................

2,020
5,370

1,780
6,010

2,380
4,590

2,880
4,020

3,400
2,330

3,910
990

4,160
410

16,730
12,350

10
11
12
13
14
15
16
17
18
19
20

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 .....................................

50
250
900
20
100
90
310
60
30
50
70

60
260
850
20
100
90
360
80
30
50
70

70
270
410
20
110
100
440
100
30
50
70

90
290
130
20
120
120
530
100
30
20
70

90
300
130
20
120
130
640
100
30
–10
70

100
310
130
20
130
140
760
90
30
–50
70

100
320
130
20
140
150
910
90
30
–50
60

450
1,490
930
100
620
640
3,280
480
150
–40
340

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 .....................................................................................
Tax incentives for preservation of historic structures ............................................................................

10
250
400
100
360
180

10
260
420
100
360
200

10
270
440
110
370
210

10
290
480
120
380
220

10
300
530
120
390
230

10
300
580
130
400
240

10
310
630
140
410
250

50
1,470
2,660
620
1,950
1,150

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 ...............................................................................................

170
120
10
990
70
10

170
130
10
1,040
70
10

170
130
10
1,100
70
10

170
130
10
1,160
70
10

170
120
10
1,220
80
10

170
120
10
1,290
80
10

170
120
10
1,360
80
10

850
620
50
6,130
380
50

1,000
60
16,290
10
220
100

1,070
50
17,710
10
230
100

1,150
30
19,250
10
250
100

1,230
20
20,940
10
260
100

1,320
10
22,780
10
280
100

1,420
0
24,790
10
290
100

1,530
0
26,930
10
300
100

6,650
60
114,690
50
1,380
500

800
160
64,510
22,410
1,040
19,090
4,800
3,220
5,190

830
170
64,190
22,680
1,050
19,670
4,400
3,330
5,440

870
180
66,110
23,580
1,080
20,260
4,070
3,460
5,710

960
200
68,070
23,210
1,100
20,860
3,780
3,630
5,790

1,050
220
70,870
20,330
1,120
21,490
3,530
3,810
5,800

1,140
240
73,560
16,300
1,140
22,140
3,290
3,980
5,720

1,240
260
76,870
14,410
1,160
22,800
3,090
4,130
5,800

5,260
1,100
355,480
97,830
5,600
107,550
17,760
19,010
28,820

30
80
67,800
70
26,540
530
40
4,540

30
80
61,810
100
27,610
600
40
4,560

30
80
60,200
130
28,710
680
40
4,240

40
80
56,990
160
29,860
760
50
3,960

40
80
56,180
210
31,050
900
50
3,800

40
80
50,670
250
32,300
1,080
50
4,160

40
80
49,880
300
33,590
1,130
50
4,880

190
400
273,920
1,050
155,510
4,550
240
21,040

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) ...................

100

ANALYTICAL PERSPECTIVES

Table 6–1.

ESTIMATES OF TOTAL INCOME TAX EXPENDITURES—Continued
(In millions of dollars)
Total from corporations and individuals
2001

2002

2003

2004

2005

2006

2007

2003–2007

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 .......................................................................................

37,860
1,670
130
4,940
310

37,130
1,430
160
5,590
310

36,480
1,420
200
6,210
330

36,790
1,390
240
6,580
360

37,430
1,360
250
7,120
390

38,520
1,480
270
7,450
430

40,930
1,720
270
7,880
470

190,150
7,370
1,230
35,240
1,980

61
62
63

Transportation:
Deferral of tax on shipping companies ..................................................................................................
Exclusion of reimbursed employee parking expenses ..........................................................................
Exclusion for employer-provided transit passes ....................................................................................

20
1,980
220

20
2,090
280

20
2,190
360

20
2,300
410

20
2,420
470

20
2,550
540

20
2,670
600

100
12,130
2,380

64
65
66
67
68
69

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, Enterprise communities, and Renewal communities ........................................
New markets tax credit ...........................................................................................................................
Expensing of environmental remediation costs .....................................................................................

30
630
60
380
10
80

30
640
60
730
90
100

30
680
60
1,130
190
100

30
750
60
1,170
290
20

30
820
70
1,280
430
–20

30
890
70
1,410
610
–10

30
980
70
1,580
830
–10

150
4,120
330
6,570
2,350
80

1,210
4,130
2,370
30
390
0
190
230
540
30
10
1,010
3,830
260

1,200
4,110
2,290
50
450
430
270
230
550
50
20
1,070
3,980
410

1,210
3,520
2,360
80
640
2,290
340
240
580
70
20
1,120
4,200
500

1,240
2,880
3,140
130
660
2,960
400
260
640
80
20
1,170
4,440
530

1,330
2,930
2,980
220
680
3,710
460
290
700
90
20
1,230
4,600
560

1,380
2,730
2,740
330
700
3,010
530
310
760
90
20
1,280
4,840
590

1,390
2,900
2,960
470
720
0
590
350
830
90
20
1,340
5,030
620

6,550
14,960
14,180
1,230
3,400
11,970
2,320
1,450
3,510
420
100
6,140
23,110
2,800

84
85
86
87
88
89
90
91
92
93
94
95
96

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 ..................................................................................................
Deduction for higher education expenses .........................................................................................
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 ...............................................................
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 ..................................................................................................................
Employer provided child care exclusion ............................................................................................
Employer-provided child care credit ..................................................................................................
Assistance for adopted foster children ..............................................................................................
Adoption credit and exclusion ............................................................................................................
Exclusion of employee meals and lodging (other than military) ......................................................
Child credit 2 ........................................................................................................................................
Credit for child and dependent care expenses .................................................................................
Credit for disabled access expenditures ...........................................................................................
Deductibility of charitable contributions, other than education and health .......................................
Exclusion of certain foster care payments ........................................................................................
Exclusion of parsonage allowances ...................................................................................................

300
90
720
0
190
130
710
19,840
2,670
50
30,150
500
350

230
70
740
40
220
140
740
19,760
2,610
50
30,810
510
370

140
40
770
90
250
220
780
19,680
2,670
50
32,080
520
400

60
20
810
130
260
450
810
19,550
2,960
50
33,830
530
420

30
10
930
150
270
500
850
20,550
2,700
60
35,190
540
450

10
0
1,020
150
280
540
890
21,530
2,150
60
36,890
570
470

0
0
1,080
160
290
560
930
21,240
1,920
60
38,290
610
490

240
70
4,610
680
1,350
2,270
4,260
102,550
12,400
280
176,280
2,770
2,230

97
98
99
100
101
102
103
104
105

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 .............................................................................................

82,800
1,520
4,730
20
4,990
1,100
4,010
140
270

90,910
1,730
4,870
20
5,260
1,130
4,180
150
300

99,260
2,420
5,080
20
5,530
1,190
4,420
170
340

106,940
3,570
5,230
20
5,840
1,310
4,690
190
310

115,380
3,870
5,410
20
6,280
1,440
4,850
220
300

124,050
4,170
5,570
20
6,600
1,570
5,100
240
270

134,960
4,430
5,790
20
7,100
1,700
5,320
270
300

580,590
18,460
27,080
100
31,350
7,210
24,380
1,090
1,520

380
5,560
370
70
110

390
5,810
380
70
120

400
6,070
400
60
120

400
6,320
410
60
120

400
6,600
430
60
130

400
6,900
450
50
130

400
7,200
470
50
140

2,000
33,090
2,160
280
640

42,070
44,080

48,070
52,960

53,080
59,510

54,500
62,770

55,630
65,290

58,980
69,230

63,320
73,320

285,510
330,120

70
71
72
73
74
75
76
77
78
79
80
81
82
83

106
107
108
109
110
111
112

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 ...................................................................................................................................
401(k) plans ........................................................................................................................................

101

6. TAX EXPENDITURES

Table 6–1.

ESTIMATES OF TOTAL INCOME TAX EXPENDITURES—Continued
(In millions of dollars)
Total from corporations and individuals

113
114
115

2001

2002

2003

2004

2005

2006

2007

2003–2007

18,680
0
6,160

18,090
550
6,520

18,660
1,960
6,770

19,050
1,940
7,040

18,930
1,900
7,250

19,230
1,800
7,490

18,330
1,280
7,730

94,200
8,880
36,280

1,750
210
0
20
1,290
40
1,970
30
210
4,940

1,780
220
20
20
1,340
40
1,890
30
250
4,370

1,800
230
50
30
1,420
40
1,950
30
310
4,800

1,830
240
90
30
1,490
40
2,060
30
360
4,930

1,860
250
120
30
1,570
40
2,100
30
410
5,100

1,890
260
130
30
1,640
40
2,150
30
450
5,180

1,920
270
150
30
1,730
40
2,050
30
490
5,390

9,300
1,250
540
150
7,850
200
10,310
150
2,020
25,400

116
117
118
119
120
121
122
123
124
125

Individual Retirement Accounts ..........................................................................................................
Low and moderate income savers credit ..........................................................................................
Keogh plans ........................................................................................................................................
Exclusion of other employee benefits:
Premiums on group term life insurance ............................................................................................
Premiums on accident and disability insurance ................................................................................
Small business retirement plan credit ...............................................................................................
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 .................................................................................................................

126
127
128

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 .....................................................................

17,830
2,690
3,720

18,000
2,930
3,870

18,180
3,240
4,060

18,560
3,630
4,320

18,850
4,020
4,560

19,720
4,470
4,820

20,890
5,020
5,170

96,200
20,380
22,930

129
130
131
132

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 .................................................................................

3,150
70
90
40

3,190
80
90
40

3,300
80
90
40

3,490
80
100
40

3,680
90
100
50

3,870
90
110
50

4,080
100
110
60

18,420
440
510
240

133
134
135

General purpose fiscal assistance:
Exclusion of interest on public purpose State and local 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 ....................

23,100
45,520
2,190

23,680
46,160
2,240

24,270
48,150
2,240

24,880
47,730
2,240

25,500
43,270
2,200

26,140
34,820
1,300

26,800
30,890
0

127,590
204,860
7,980

136

Interest:
Deferral of interest on U.S. savings bonds ...........................................................................................

290

300

310

330

330

350

360

1,680

22,410
45,520

22,680
46,160

23,580
48,150

23,210
47,730

20,330
43,270

16,300
34,820

14,410
30,890

97,830
204,860

23,100
90
400
310
800
160
630
230
540
1,100
40
30

23,680
90
420
310
830
170
640
230
550
1,130
40
50

24,270
100
440
330
870
180
680
240
580
1,190
40
70

24,880
120
480
360
960
200
750
260
640
1,310
40
80

25,500
130
530
390
1,050
220
820
290
700
1,440
50
90

26,140
140
580
430
1,140
240
890
310
760
1,570
50
90

26,800
150
630
470
1,240
260
980
350
830
1,700
60
90

127,590
640
2,660
1,980
5,260
1,100
4,120
1,450
3,510
7,210
240
420

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 State and local bonds for:
Public purposes ..................................................................................................................................
Energy facilities ...................................................................................................................................
Water, sewage, and hazardous waste disposal facilities .................................................................
Small-issues ........................................................................................................................................
Owner-occupied mortgage subsidies .................................................................................................
Rental housing ....................................................................................................................................
Airports, docks, and similar facilities .................................................................................................
Student loans ......................................................................................................................................
Private nonprofit educational facilities ...............................................................................................
Hospital construction ..........................................................................................................................
Veterans’ housing ...............................................................................................................................
Credit for holders of zone academy bonds ...........................................................................................

1 The determination of whether a provision is a tax expenditure is made on the basis of a broad concept of ‘‘income’’ that is larger in scope than is ‘‘income’’ as defined under general U.S. income tax
principles. For tax reasons, the tax expenditure estimates include, for example, estimates related to the exclusion of extraterritorial income, as well as other exclusions, notwithstanding that such exclusions
define income under the general rule of U.S. income taxation.
2 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: 2001 $990; 2002 $1,020; 2003 $1,050; 2004 $1,080;
2005 $1,080; 2006 $1,100; and 2007 $1,120.
3 The figures in the table indicate the effect of the child tax credit on receipts. The effect of the credit on outlays (in millions of dollars) is as follows: 2001 $980; 2002 $7,390; 2003 $7,390; 2004 $7,210;
2005 $6,950; 2006 $9,380; and 2007 $9,200.
4 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect of the credit on outlays (in millions of dollars) is as follows: 2001 $26,120; 2002 $28,280; 2003
$30,630; 2004 $31,080; 2005 $31,720; 2006 $33,130; and 2007 $34,090.
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 $10 million. Provisions with estimates that rounded to zero in each year are not included in the table.

102

ANALYTICAL PERSPECTIVES

Table 6–2.

CORPORATE AND INDIVIDUAL INCOME TAX ESTIMATES OF TAX EXPENDITURES
(In millions of dollars)
Corporations

2001

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

2002

2003

2004

2005

Individuals
2006

2007

2003–
2007

National Defense
Exclusion of benefits and allowances to armed forces personnel ............ ............ ............ ............ ............ ............ ............ ..............

2001

2002

2,160

2,190

2003

2,210

2004

2,240

International affairs:
Exclusion of income earned abroad
by U.S. citizens ........................... ............ ............ ............ ............ ............ ............ ............ .............. 2,450 2,540
2,660
2,690
Exclusion of certain allowances for
Federal employees abroad ......... ............ ............ ............ ............ ............ ............ ............ ..............
760
800
840
880
Extraterritorial income exclusion .....
4,490 4,820 5,150 5,510 5,890 6,290 6,730 29,570 ............ ............ .............. ..............
Inventory property sales source
rules exception ............................
1,400 1,470 1,540 1,620 1,700 1,790 1,880
8,530 ............ ............ .............. ..............
Deferral of income from controlled
foreign corporations (normal tax
method) .......................................
6,600 7,000 7,450 7,900 8,400 8,930 9,550 42,230 ............ ............ .............. ..............
Deferred taxes for financial firms
on certain income earned overseas .............................................
1,300
550 ............ ............ ............ ............ ............
0 ............ ............ .............. ..............
General science, space, and technology:
Expensing of research and experimentation expenditures (normal
tax method) .................................
Credit for increasing research activities ..........................................

2005

2006

2007

2003–
2007

2,260

2,290

2,310

11,310

2,760

2,810

3,170

14,090

920
960
1,020
4,620
.............. .............. .............. ..............
.............. .............. .............. ..............
.............. .............. .............. ..............
.............. .............. .............. ..............

1,980

1,750

2,330

2,820

3,330

3,830

4,080

16,390

40

30

50

60

70

80

80

340

5,310

5,950

4,540

3,980

2,310

990

410

12,240

60

60

50

40

20 .............. ..............

110

Energy:
Expensing of exploration and development costs, fuels ................
40
50
60
70
70
80
80
360
10
10
10
20
20
20
20
90
Excess of percentage over cost
depletion, fuels ............................
220
230
240
250
260
270
280
1,300
30
30
30
40
40
40
40
190
Alternative fuel production credit ....
860
810
390
120
120
120
120
870
40
40
20
10
10
10
10
60
Exception from passive loss limitation for working interests in oil
and gas properties ...................... ............ ............ ............ ............ ............ ............ ............ ..............
20
20
20
20
20
20
20
100
Capital gains treatment of royalties
on coal ........................................ ............ ............ ............ ............ ............ ............ ............ ..............
100
100
110
120
120
130
140
620
Exclusion of interest on energy facility bonds ..................................
20
20
20
30
30
30
30
140
70
70
80
90
100
110
120
500
Enhanced oil recovery credit ..........
280
330
400
480
580
690
830
2,980
30
30
40
50
60
70
80
300
New technology credit ....................
60
80
100
100
100
90
90
480 ............ ............ .............. .............. .............. .............. .............. ..............
Alcohol fuel credits 1 .......................
20
20
20
20
20
20
20
100
10
10
10
10
10
10
10
50
Tax credit and deduction for cleanfuel burning vehicles ...................
30
30
20
0
–20
–40
–40
–80
20
20
30
20
10
–10
–10
40
Exclusion from income of conservation subsidies provided by
public utilities .............................. ............ ............ ............ ............ ............ ............ ............ ..............
70
70
70
70
70
70
60
340
Natural resources and environment:
Expensing of exploration and development costs, nonfuel minerals ............................................
10
10
10
10
10
10
10
50 ............ ............ .............. .............. .............. .............. .............. ..............
Excess of percentage over cost
depletion, nonfuel minerals ........
240
250
260
270
280
280
290
1,380
10
10
10
20
20
20
20
90
Exclusion of interest on bonds for
water, sewage, and hazardous
waste facilities .............................
100
110
110
110
110
120
120
570
300
310
330
370
420
460
510
2,090
Capital gains treatment of certain
timber income ............................. ............ ............ ............ ............ ............ ............ ............ ..............
100
100
110
120
120
130
140
620
Expensing of multiperiod timber
growing costs ..............................
240
240
250
260
260
270
280
1,320
120
120
120
120
130
130
130
630
Tax incentives for preservation of
historic structures ........................
170
180
190
200
210
220
230
1,050
10
20
20
20
20
20
20
100
Agriculture:
Expensing of certain capital outlays
20
20
20
20
20
20
20
100
150
150
150
150
150
150
150
750
Expensing of certain multiperiod
production costs ..........................
10
20
20
20
20
20
20
100
110
110
110
110
100
100
100
520
Treatment of loans forgiven for solvent farmers ................................ ............ ............ ............ ............ ............ ............ ............ ..............
10
10
10
10
10
10
10
50
Capital gains treatment of certain
income ......................................... ............ ............ ............ ............ ............ ............ ............ ..............
990 1,040
1,100
1,160
1,220
1,290
1,360
6,130
Income averaging for farmers ........ ............ ............ ............ ............ ............ ............ ............ ..............
70
70
70
70
80
80
80
380
Deferral of gain on sale of farm refiners ...........................................
10
10
10
10
10
10
10
50 ............ ............ .............. .............. .............. .............. .............. ..............

103

6. TAX EXPENDITURES

Table 6–2.

CORPORATE AND INDIVIDUAL INCOME TAX ESTIMATES OF TAX EXPENDITURES—Continued
(In millions of dollars)
Corporations

33
34
35
36

37

38

39

40
41
42

43
44
45

46
47

48
49
50

51
52
53
54

55

56

57

58
59
60

61

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 owneroccupied 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 ............................
Transportation:
Deferral of tax on shipping companies ..............................................

Individuals
2003–
2007

2002

2003

2004

2005

2006

2007

1,000

1,070

1,150

1,230

1,320

1,420

1,530

6,650 ............ ............ .............. .............. .............. .............. .............. ..............

60

50

30

20

10

0

0

60 ............ ............ .............. .............. .............. .............. .............. ..............

1,650

1,770

1,890

2,020

2,160

2,280

2,490

10

10

10

10

10

10

10

50 ............ ............ .............. .............. .............. .............. .............. ..............

220

230

250

260

280

290

300

1,380 ............ ............ .............. .............. .............. .............. .............. ..............

100

100

100

100

100

100

100

500 ............ ............ .............. .............. .............. .............. .............. ..............

200

210

210

220

230

230

240

1,130

600

620

660

740

820

910

1,000

4,130

40

40

40

50

50

50

50

240

120

130

140

150

170

190

210

860

............ ............ ............ ............ ............ ............ ............ .............. 64,510 64,190

66,110

68,070

70,870

73,560

76,870 355,480

............ ............ ............ ............ ............ ............ ............ .............. 22,410 22,680

23,580

23,210

20,330

16,300

14,410

97,830

780

800

810

830

840

860

4,140

............ ............ ............ ............ ............ ............ ............ .............. 19,090 19,670

20,260

20,860

21,490

22,140

270

270

280

290

290

300

300

2001

2002

10,840 14,640 15,940

1,460

............ ............ ............ ............ ............ ............ ............ ..............

770

2003

17,360

2004

18,920

2005

20,620

2006

22,510

2007

2003–
2007

2001

24,440 103,850

22,800 107,550

4,800

4,400

4,070

3,780

3,530

3,290

3,090

17,760

2,420

2,500

2,600

2,730

2,860

2,990

3,100

14,280

800

830

860

900

950

990

1,030

4,730

390

410

440

450

460

470

480

2,300

4,800

5,030

5,270

5,340

5,340

5,250

5,320

26,520

............ ............ ............ ............ ............ ............ ............ ..............

30

30

30

40

40

40

40

190

............ ............ ............ ............ ............ ............ ............ ..............

80

80

80

80

80

80

80

400

............ ............ ............ ............ ............ ............ ............ .............. 67,800 61,810

60,200

56,990

56,180

50,670

100

130

160

210

250

............ ............ ............ ............ ............ ............ ............ .............. 26,540 27,610

28,710

29,860

31,050

32,300

............ ............ ............ ............ ............ ............ ............ ..............

70

49,880 273,920
300

1,050

33,590 155,510

............ ............ ............ ............ ............ ............ ............ ..............

530

600

680

760

900

1,080

1,130

4,550

............ ............ ............ ............ ............ ............ ............ ..............

40

40

40

50

50

50

50

240

10,980

1,850

1,940

1,790

1,780

1,810

2,110

2,570

10,060

30,750 30,220 29,750 30,200 30,860 31,970 34,070 156,850

7,110

6,910

6,730

6,590

6,570

6,550

6,860

33,300

2,690

2,620

2,450

2,180

1,990

2,050

2,310

530

470

460

460

450

490

570

2,430

1,140

960

960

930

910

990

1,150

4,940

90

110

140

160

170

180

180

830

40

50

60

80

80

90

90

400

4,940

5,590

6,210

6,580

7,120

7,450

7,880

80

80

80

80

80

90

90

420

20

20

20

20

20

20

20

100 ............ ............ .............. .............. .............. .............. .............. ..............

35,240 ............ ............ .............. .............. .............. .............. .............. ..............
230

230

250

280

310

340

380

1,560

104

ANALYTICAL PERSPECTIVES

Table 6–2.

CORPORATE AND INDIVIDUAL INCOME TAX ESTIMATES OF TAX EXPENDITURES—Continued
(In millions of dollars)
Corporations
2001

62
63

64
65
66
67

68
69

70

71
72
73
74
75
76
77
78

79
80

81
82
83

84
85
86
87
88
89
90

91
92
93
94

95

2002

2003

2004

2005

Individuals
2006

2003–
2007

2007

Exclusion of reimbursed employee
parking expenses ........................ ............ ............ ............ ............ ............ ............ ............ ..............
Exclusion for employer-provided
transit passes .............................. ............ ............ ............ ............ ............ ............ ............ ..............
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, Enterprise
communities, and Renewal communities .......................................
New markets tax credit ...................
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 .......................................
Deduction for higher education
expenses ................................
State prepaid tuition plans .........
Exclusion of interest on studentloan 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 ........
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 ..........
Employer provided child care exclusion .....................................
Employer-provided child care
credit .......................................
Assistance for adopted foster
children ...................................
Adoption credit and exclusion ....
Exclusion of employee meals
and lodging (other than military) .........................................
Child credit 2 ...............................
Credit for child and dependent
care expenses ........................
Credit for disabled access expenditures ...............................
Deductibility of charitable contributions, other than education and health ....................
Exclusion of certain foster care
payments ................................

2003

2004

2005

2006

2003–
2007

2001

2002

2007

1,980

2,090

2,190

2,300

2,420

2,550

2,670

12,130

220

280

360

410

470

540

600

2,380

20

20

20

20

20

20

20

100

10

10

10

10

10

10

10

50

160

160

170

170

180

180

190

890

470

480

510

580

640

710

790

3,230

60

60

60

60

70

70

70

100
0

220
20

300
50

300
70

320
110

350
150

390
210

1,660
590

280
10

510
70

70

80

80

20

–20

–10

–10

60

10

20

............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............

1,210
4,130
2,370

1,200
4,110
2,290

1,210
3,520
2,360

1,240
2,880
3,140

1,330
2,930
2,980

1,380
2,730
2,740

1,390
2,900
2,960

6,550
14,960
14,180

............ ............ ............ ............ ............ ............ ............ ..............

30

50

80

130

220

330

470

1,230

............ ............ ............ ............ ............ ............ ............ ..............

390

450

640

660

680

700

720

3,400

............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............

0
190

430
270

2,290
340

2,960
400

3,710
460

3,010
530

0
590

11,970
2,320

330 ............ ............ .............. .............. .............. .............. .............. ..............

830
140

870
220

960
320

1,060
460

1,190
620

4,910
1,760

20 .............. .............. .............. ..............

20

60

60

60

60

60

60

70

310

170

170

180

200

230

250

280

1,140

140

140

140

150

150

150

160

750

400

410

440

490

550

610

670

2,760

30

50

70

80

90

90

90

420 ............ ............ .............. .............. .............. .............. .............. ..............

............ ............ ............ ............ ............ ............ ............ ..............

10

20

20

20

20

20

20

100

............ ............ ............ ............ ............ ............ ............ ..............

1,010

1,070

1,120

1,170

1,230

1,280

1,340

6,140

4,290

3,240

3,300

3,430

3,610

3,760

3,940

4,080

18,820

............ ............ ............ ............ ............ ............ ............ ..............

260

410

500

530

560

590

620

2,800

200
60

40
10

40
10

20
10

10
0

10
0

0
0

0
0

40
10

............ ............ ............ ............ ............ ............ ............ ..............

720

740

770

810

930

1,020

1,080

4,610

590

260
80

0

680

190
60

40

770

120
30

90

830

50
20

130

840

20
10

150

900

10
0

150

950

0
0

160

680 ............ ............ .............. .............. .............. .............. .............. ..............

............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............

220
140

250
220

260
450

270
500

280
540

............ ............ ............ ............ ............ ............ ............ ..............
710
740
............ ............ ............ ............ ............ ............ ............ .............. 19,840 19,760

780
19,680

810
19,550

850
20,550

890
21,530

............ ............ ............ ............ ............ ............ ............ ..............
10

10

10

10

20

20

20

730

850

950

1,040

1,040

1,110

1,180

190
130

290
560

1,350
2,270

930
4,260
21,240 102,550

2,670

2,610

2,670

2,960

2,700

2,150

1,920

12,400

40

40

40

40

40

40

40

200

5,320 29,420 29,960

31,130

32,790

34,150

35,780

520

530

540

570

80

............ ............ ............ ............ ............ ............ ............ ..............

500

510

37,110 170,960
610

2,770

105

6. TAX EXPENDITURES

Table 6–2.

CORPORATE AND INDIVIDUAL INCOME TAX ESTIMATES OF TAX EXPENDITURES—Continued
(In millions of dollars)
Corporations
2001

96

97

98
99
100
101
102
103
104
105

106
107
108
109
110

111
112
113
114
115

116
117
118
119
120
121
122
123
124
125

126
127
128

129
130
131
132

2002

2003

2004

2005

Individuals
2006

2007

2003–
2007

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 .........................................
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 ...........................
401(k) plans ................................
Individual Retirement Accounts ..
Low and moderate income savers credit .................................
Keogh plans ................................
Exclusion of other employee benefits:
Premiums on group term life insurance ...................................
Premiums on accident and disability insurance ......................
Small business retirement plan
credit ...........................................
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 .............

2001

2002

350

370

............ ............ ............ ............ ............ ............ ............ .............. 82,800 90,910

2003

400

2004

420

2005

450

2006

470

2007

490

2003–
2007

2,230

99,260 106,940 115,380 124,050 134,960 580,590

............ ............ ............ ............ ............ ............ ............ ..............

1,520

1,730

2,420

3,570

3,870

4,170

4,430

18,460

............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............

4,730
20
4,990

4,870
20
5,260

5,080
20
5,530

5,230
20
5,840

5,410
20
6,280

5,570
20
6,600

5,790
20
7,100

27,080
100
31,350

280

290

290

300

310

320

320

1,540

820

840

900

1,010

1,130

1,250

1,380

5,670

710

820

920

1,010

1,010

1,080

1,150

5,170

3,300

3,360

3,500

3,680

3,840

4,020

4,170

19,210

140

150

170

190

220

240

270

1,090 ............ ............ .............. .............. .............. .............. .............. ..............

270

300

340

310

300

270

300

1,520 ............ ............ .............. .............. .............. .............. .............. ..............

............ ............ ............ ............ ............ ............ ............ ..............

380

390

400

400

400

400

400

2,000

............ ............ ............ ............ ............ ............ ............ ..............

5,560

5,810

6,070

6,320

6,600

6,900

7,200

33,090

............ ............ ............ ............ ............ ............ ............ ..............

370

380

400

410

430

450

470

2,160

............ ............ ............ ............ ............ ............ ............ ..............

70

70

60

60

60

50

50

280

............ ............ ............ ............ ............ ............ ............ ..............

110

120

120

120

130

130

140

640

............ ............ ............ ............ ............ ............ ............ .............. 42,070 48,070
............ ............ ............ ............ ............ ............ ............ .............. 44,080 52,960
............ ............ ............ ............ ............ ............ ............ .............. 18,680 18,090

53,080
59,510
18,660

54,500
62,770
19,050

55,630
65,290
18,930

58,980
69,230
19,230

63,320 285,510
73,320 330,120
18,330 94,200

............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............

0
6,160

550
6,520

1,960
6,770

1,940
7,040

1,900
7,250

1,800
7,490

1,280
7,730

8,880
36,280

............ ............ ............ ............ ............ ............ ............ ..............

1,750

1,780

1,800

1,830

1,860

1,890

1,920

9,300

............ ............ ............ ............ ............ ............ ............ ..............

210

220

230

240

250

260

270

1,250

0

10

20

40

50

50

60

220

0

10

30

50

70

80

90

320

20
20
30
30
30
30
30
150 ............ ............ .............. .............. .............. .............. .............. ..............
980 1,020 1,080 1,140 1,200 1,260 1,330
6,010
310
320
340
350
370
380
400
1,840
............ ............ ............ ............ ............ ............ ............ ..............
40
40
40
40
40
40
40
200
............ ............ ............ ............ ............ ............ ............ .............. 1,970 1,890
1,950
2,060
2,100
2,150
2,050 10,310
............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............
............ ............ ............ ............ ............ ............ ............ ..............

30
250
4,370

30
310
4,800

30
360
4,930

30
410
5,100

30
450
5,180

30
490
5,390

150
2,020
25,400

Social Security:
Exclusion of social security benefits:
Social Security benefits for retired workers ........................... ............ ............ ............ ............ ............ ............ ............ .............. 17,830 18,000
Social Security benefits for disabled ....................................... ............ ............ ............ ............ ............ ............ ............ .............. 2,690 2,930
Social Security benefits for dependents and survivors .......... ............ ............ ............ ............ ............ ............ ............ .............. 3,720 3,870

18,180

18,560

18,850

19,720

20,890

96,200

3,240

3,630

4,020

4,470

5,020

20,380

4,060

4,320

4,560

4,820

5,170

22,930

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

30
210
4,940

3,150
70
90

3,190
80
90

3,300
80
90

3,490
80
100

3,680
90
100

3,870
90
110

4,080
100
110

18,420
440
510

30

30

30

30

40

40

50

190

106

ANALYTICAL PERSPECTIVES

Table 6–2.

CORPORATE AND INDIVIDUAL INCOME TAX ESTIMATES OF TAX EXPENDITURES—Continued
(In millions of dollars)
Corporations
2001

133
134

135

136

2002

2003

2004

2005

Individuals
2006

2007

2003–
2007

2001

2002

2003

2004

2005

2006

2007

2003–
2007

General purpose fiscal assistance:
Exclusion of interest on public purpose State and local bonds .......
5,860 6,010 6,160 6,310 6,470 6,630 6,800 32,370 17,240 17,670 18,110 18,570 19,030 19,510 20,000 95,220
Deductibility of nonbusiness state
and local taxes other than on
owner-occupied homes ............... ............ ............ ............ ............ ............ ............ ............ .............. 45,520 46,160 48,150 47,730 43,270 34,820 30,890 204,860
Tax credit for corporations receiving income from doing business
in U.S. possessions ....................
2,190 2,240 2,240 2,240 2,200 1,300
0
7,980 ............ ............ .............. .............. .............. .............. .............. ..............
Interest:
Deferral of interest on U.S. savings
bonds .......................................... ............ ............ ............ ............ ............ ............ ............ ..............

290

300

310

330

330

350

360

1,680

Addendum: Aid to State and local
governments:
Deductibility of:
Property taxes on owner-occupied homes ............................. ............ ............ ............ ............ ............ ............ ............ .............. 22,410 22,680 23,580 23,210 20,330 16,300 14,410 97,830
Nonbusiness State and local
taxes other than on owner-occupied homes ......................... ............ ............ ............ ............ ............ ............ ............ .............. 45,520 46,160 48,150 47,730 43,270 34,820 30,890 204,860
Exclusion of interest on State and
local bonds for:
Public purposes ..........................
5,860 6,010 6,160 6,310 6,470 6,630 6,800 32,370 17,240 17,670 18,110 18,570 19,030 19,510 20,000 95,220
Energy facilities ...........................
20
20
20
30
30
30
30
140
70
70
80
90
100
110
120
500
Water, sewage, and hazardous
waste disposal facilities ..........
100
110
110
110
110
120
120
570
300
310
330
370
420
460
510
2,090
Small-issues ................................
80
80
80
80
80
90
90
420
230
230
250
280
310
340
380
1,560
Owner-occupied mortgage subsidies .......................................
200
210
210
220
230
230
240
1,130
600
620
660
740
820
910
1,000
4,130
Rental housing ............................
40
40
40
50
50
50
50
240
120
130
140
150
170
190
210
860
Airports, docks, and similar facilities ......................................
160
160
170
170
180
180
190
890
470
480
510
580
640
710
790
3,230
Student loans ..............................
60
60
60
60
60
60
70
310
170
170
180
200
230
250
280
1,140
Private nonprofit educational facilities ......................................
140
140
140
150
150
150
160
750
400
410
440
490
550
610
670
2,760
Hospital construction ..................
280
290
290
300
310
320
320
1,540
820
840
900
1,010
1,130
1,250
1,380
5,670
Veterans’ housing .......................
10
10
10
10
10
10
10
50
30
30
30
30
40
40
50
190
Credit for holders of zone academy
bonds ..........................................
30
50
70
80
90
90
90
420 ............ ............ .............. .............. .............. .............. .............. ..............
1 The determination of whether a provision is a tax expenditure is made on the basis of a broad concept of ‘‘income’’ that is larger in scope than is ‘‘income’’ as defined under general U.S. income
tax principles. For tax reasons, the tax expenditure estimates include, for example, estimates related to the exclusion of extraterritorial income, as well as other exclusions, notwithstanding that such exclusions define income under the general rule of U.S. income taxation.
2 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: 2001 $990; 2002 $1,020; 2003 $1,050; 2004
$1,080; 2005 $1,080; 2006 $1,100; and 2007 $1,120.
3 The figures in the table indicate the effect of the child tax credit on receipts. The effect of the credit on outlays (in millions of dollars) is as follows: 2001 $980; 2002 $7,390; 2003 $7,390; 2004
$7,210; 2005 $6,950; 2006 $9,380; and 2007 $9,200.
4 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect of the credit on outlays (in millions of dollars) is as follows: 2001 $26,120; 2002 $28,280; 2003
$30,630; 2004 $31,080; 2005 $31,720; 2006 $33,130; and 2007 $34,090.

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 $10 million. Provisions with estimates that rounded to zero in each year are not included in the table.

107

6. TAX EXPENDITURES

Table 6–3.

INCOME TAX EXPENDITURES RANKED BY TOTAL 2003 PROJECTED REVENUE EFFECT
(In millions of dollars)
Provision

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) ..........................................................
Net exclusion of pension contributions and earnings: 401(k) plans ..................................................................................
Net exclusion of pension contributions and earnings: Employer plans .............................................................................
Deductibility of nonbusiness state and local taxes other than on owner-occupied homes ..............................................
Accelerated depreciation of machinery and equipment (normal tax method) ...................................................................
Deductibility of charitable contributions, other than education and health .........................................................................
Step-up basis of capital gains at death ..............................................................................................................................
Exclusion of interest on public purpose State and local bonds .........................................................................................
Deductibility of State and local property tax on owner-occupied homes ...........................................................................
Capital gains exclusion on home sales ...............................................................................................................................
Child credit ............................................................................................................................................................................
Exclusion of interest on life insurance savings ...................................................................................................................
Net exclusion of pension contributions and earnings: Individual Retirement Accounts ....................................................
Exclusion of Social Security benefits for retired workers ...................................................................................................
Deferral of income from controlled foreign corporations (normal tax method) ..................................................................
Net exclusion of pension contributions and earnings: Keogh plans ..................................................................................
Graduated corporation income tax rate (normal tax method) ............................................................................................
Exclusion of workers’ compensation benefits ......................................................................................................................
Accelerated depreciation on rental housing (normal tax method) ......................................................................................
Deductibility of medical expenses ........................................................................................................................................
Extraterritorial income exclusion ..........................................................................................................................................
Workers’ compensation insurance premiums ......................................................................................................................
Earned income tax credit .....................................................................................................................................................
Credit for increasing research activities ..............................................................................................................................
Deductibility of charitable contributions (health) ..................................................................................................................
Accelerated depreciation of buildings other than rental housing (normal tax method) .....................................................
Deductibility of charitable contributions (education) ............................................................................................................
Exception from passive loss rules for $25,000 of rental loss ............................................................................................
Exclusion of Social Security benefits for dependents and survivors .................................................................................
HOPE tax credit ...................................................................................................................................................................
Credit for low-income housing investments .........................................................................................................................
Exclusion of veterans death benefits and disability compensation ....................................................................................
Exclusion of Social Security benefits for disabled ..............................................................................................................
Credit for child and dependent care expenses ...................................................................................................................
Exclusion of income earned abroad by U.S. citizens .........................................................................................................
Self-employed medical insurance premiums .......................................................................................................................
Expensing of research and experimentation expenditures (normal tax method) ..............................................................
Lifetime Learning tax credit ..................................................................................................................................................
Deduction for higher education expenses ...........................................................................................................................
Tax credit for corporations receiving income from doing business in U.S. possessions ..................................................
Exclusion of benefits and allowances to armed forces personnel .....................................................................................
Exclusion of reimbursed employee parking expenses ........................................................................................................
Net exclusion of pension contributions and earnings: Low and moderate income savers credit .....................................
Additional deduction for the elderly .....................................................................................................................................
Net exclusion of pension contributions and earnings: Premiums on group term life insurance .......................................
Inventory property sales source rules exception .................................................................................................................
Special ESOP rules ..............................................................................................................................................................
Expensing of certain small investments (normal tax method) ............................................................................................
Exclusion of scholarship and fellowship income (normal tax method) ..............................................................................
Exclusion of interest on hospital construction bonds ..........................................................................................................
Exemption of credit union income .......................................................................................................................................
Empowerment zones, Enterprise communities, and Renewal communities ......................................................................
Parental personal exemption for students age 19 or over .................................................................................................
Capital gains treatment of certain income ...........................................................................................................................
Deferral of income from post 1987 installment sales .........................................................................................................
Exclusion of interest on owner-occupied mortgage subsidy bonds ...................................................................................
Exclusion of certain allowances for Federal employees abroad ........................................................................................
Exclusion of employee meals and lodging (other than military) ........................................................................................
Employer provided child care exclusion ..............................................................................................................................
Carryover basis of capital gains on gifts .............................................................................................................................
Exclusion of interest for airport, dock, and similar bonds ..................................................................................................
Deductibility of student-loan interest ....................................................................................................................................
Exclusion of interest on bonds for private nonprofit educational facilities .........................................................................
Exclusion of certain foster care payments ..........................................................................................................................
Exclusion of employer-provided educational assistance .....................................................................................................
Enhanced oil recovery credit ...............................................................................................................................................
Exclusion of interest on bonds for water, sewage, and hazardous waste facilities ..........................................................

2003
99,260
66,110
60,200
59,510
53,080
48,150
36,480
32,080
28,710
24,270
23,580
20,260
19,680
19,250
18,660
18,180
7,450
6,770
6,210
6,070
5,710
5,530
5,150
5,080
4,800
4,590
4,420
4,240
4,200
4,070
4,060
3,520
3,460
3,300
3,240
2,670
2,660
2,420
2,380
2,360
2,290
2,240
2,210
2,190
1,960
1,950
1,800
1,540
1,420
1,420
1,210
1,190
1,150
1,130
1,120
1,100
1,080
870
840
780
770
680
680
640
580
520
500
440
440

2003–2007
580,590
355,480
273,920
330,120
285,510
204,860
190,150
176,280
155,510
127,590
97,830
107,550
102,550
114,690
94,200
96,200
42,230
36,280
35,240
33,090
28,820
31,350
29,570
27,080
25,400
12,350
24,380
21,040
23,110
17,760
22,930
14,960
19,010
18,420
20,380
12,400
14,090
18,460
16,730
14,180
11,970
7,980
11,310
12,130
8,880
10,310
9,300
8,530
7,850
7,370
6,550
7,210
6,650
6,570
6,140
6,130
5,600
5,260
4,620
4,260
4,610
4,550
4,120
3,400
3,510
2,770
2,800
3,280
2,660

108

ANALYTICAL PERSPECTIVES

Table 6–3.

INCOME TAX EXPENDITURES RANKED BY TOTAL 2003 PROJECTED REVENUE EFFECT—Continued
(In millions of dollars)
Provision

Alternative fuel production credit .........................................................................................................................................
Exclusion of parsonage allowances .....................................................................................................................................
Exclusion of public assistance benefits (normal tax method) ............................................................................................
Exclusion of railroad retirement system benefits ................................................................................................................
Expensing of multiperiod timber growing costs ...................................................................................................................
Exclusion for employer-provided transit passes ..................................................................................................................
State prepaid tuition plans ...................................................................................................................................................
Special Blue Cross/Blue Shield deduction ..........................................................................................................................
Exclusion of interest on small issue bonds .........................................................................................................................
Deductibility of casualty losses ............................................................................................................................................
Deferral of interest on U.S. savings bonds .........................................................................................................................
Excess of percentage over cost depletion, fuels ................................................................................................................
Excess of percentage over cost depletion, nonfuel minerals .............................................................................................
Tax exemption of certain insurance companies owned by tax-exempt organizations ......................................................
Assistance for adopted foster children ................................................................................................................................
Exclusion of interest on student-loan bonds .......................................................................................................................
Net exclusion of pension contributions and earnings: Premiums on accident and disability insurance ..........................
Adoption credit and exclusion ..............................................................................................................................................
Tax incentives for preservation of historic structures .........................................................................................................
Amortization of start-up costs (normal tax method) ............................................................................................................
New markets tax credit ........................................................................................................................................................
Exclusion of interest on rental housing bonds ....................................................................................................................
Tax credit for orphan drug research ....................................................................................................................................
Expensing of certain capital outlays ....................................................................................................................................
Work opportunity tax credit ..................................................................................................................................................
Capital gains exclusion of small corporation stock .............................................................................................................
Expensing of certain multiperiod production costs ..............................................................................................................
Exclusion of military disability pensions ..............................................................................................................................
Capital gains treatment of royalties on coal .......................................................................................................................
Capital gains treatment of certain timber income ...............................................................................................................
Exclusion of interest on energy facility bonds ....................................................................................................................
Small life insurance company deduction .............................................................................................................................
New technology credit ..........................................................................................................................................................
Expensing of environmental remediation costs ...................................................................................................................
Employer-provided child care credit ....................................................................................................................................
Exclusion of GI bill benefits .................................................................................................................................................
Education Individual Retirement Accounts ..........................................................................................................................
Exclusion of veterans pensions ...........................................................................................................................................
Exceptions from imputed interest rules ...............................................................................................................................
Expensing of exploration and development costs, fuels ....................................................................................................
Credit for holders of zone academy bonds .........................................................................................................................
Income averaging for farmers ..............................................................................................................................................
Exclusion from income of conservation subsidies provided by public utilities ...................................................................
Exemption of certain mutuals’ and cooperatives’ income ..................................................................................................
Exclusion of special benefits for disabled coal miners .......................................................................................................
Small business retirement plan credit .................................................................................................................................
Credit for disabled access expenditures .............................................................................................................................
Tax credit and deduction for clean-fuel burning vehicles ...................................................................................................
Ordinary income treatment of loss from small business corporation stock sale ...............................................................
Exclusion of interest on veterans housing bonds ...............................................................................................................
Additional deduction for the blind ........................................................................................................................................
Welfare-to-work tax credit ....................................................................................................................................................
Cancellation of indebtedness ...............................................................................................................................................
Alcohol fuel credits ...............................................................................................................................................................
Investment credit for rehabilitation of structures (other than historic) ................................................................................
Income of trusts to finance supplementary unemployment benefits ..................................................................................
Tax credit for the elderly and disabled ...............................................................................................................................
Excess bad debt reserves of financial institutions ..............................................................................................................
Exception from passive loss limitation for working interests in oil and gas properties .....................................................
Deferral of tax on shipping companies ...............................................................................................................................
Exclusion of interest on savings bonds redeemed to finance educational expenses .......................................................
Medical Savings Accounts ...................................................................................................................................................
Expensing of exploration and development costs, nonfuel minerals .................................................................................
Treatment of loans forgiven for solvent farmers .................................................................................................................
Deferral of gain on sale of farm refiners .............................................................................................................................
Special alternative tax on small property and casualty insurance companies ..................................................................
Deferred taxes for financial firms on certain income earned overseas .............................................................................

2003
410
400
400
400
370
360
340
340
330
310
310
270
270
250
250
240
230
220
210
200
190
180
170
170
140
130
130
120
110
110
100
100
100
100
90
90
80
80
80
70
70
70
70
60
60
50
50
50
40
40
40
40
30
30
30
30
30
30
20
20
20
20
10
10
10
10
0

2003–2007
930
2,230
2,160
2,000
1,950
2,380
2,320
1,520
1,980
2,020
1,680
1,490
1,470
1,380
1,350
1,450
1,250
2,270
1,150
1,230
2,350
1,100
1,090
850
240
1,050
620
640
620
620
640
500
480
80
590
510
1,230
440
400
450
420
380
340
330
280
540
280
–40
240
240
200
70
190
150
150
150
150
60
100
100
100
100
50
50
50
50
0

109

6. TAX EXPENDITURES

Table 6–4.

PRESENT VALUE OF SELECTED TAX EXPENDITURES FOR ACTIVITY IN
CALENDAR YEAR 2001
(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
24
25

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 .........................................................................................................
Deferral for state prepaid tuition plans .................................................................................................................
Exclusion of pension contributions - employer plans ..........................................................................................
Exclusion of 401(k) contributions ..........................................................................................................................
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’’ is another theoretical measure of the budget effect of tax expenditures.
It is the amount of budget outlays that would be required to provide the taxpayer the same after-tax inTable 6–5.

6,760
1,170
1,700
130
0
220
230
260
22,920
4,750
540
31,210
990
20
20
120
2,850
190
97,290
69,980
6,090
9,780
20,730
5,560
330

come as would be received through the tax provision.
The outlay-equivalent measure allows the cost of a tax
expenditure to be compared with a direct Federal outlay
on a more even footing. Outlay equivalents are reported
in Table 6–5.

OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX
(In millions of dollars)
Outlay Equivalents
2001

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

National Defense
Exclusion of benefits and allowances to armed forces personnel .......................................................
International affairs:
Exclusion of income earned abroad by U.S. citizens ...........................................................................
Exclusion of certain allowances for Federal employees abroad ..........................................................
Extraterritorial income exclusion .............................................................................................................
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 ................................................
General science, space, and technology:
Expensing of research and experimentation expenditures (normal tax method) .................................
Credit for increasing research activities .................................................................................................
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 .....................................

2002

2003

2004

2005

2006

2007

2003–2007

2,510

2,540

2,570

2,600

2,620

2,650

2,680

13,120

3,270
1,020
6,910
2,150
6,600
1,300

3,380
1,060
7,410
2,260
7,000
550

3,540
1,130
7,930
2,370
7,450
..............

3,570
1,170
8,470
2,490
7,900
..............

3,670
1,230
9,060
2,620
8,400
..............

3,720
1,270
9,680
2,750
8,930
..............

4,210
1,350
10,350
2,890
9,550
..............

18,710
6,150
45,490
13,120
42,230
0

2,020
8,270

1,780
9,240

2,380
7,060

2,880
6,190

3,400
3,580

3,910
1,530

4,160
640

16,730
18,990

80
290
1,210
20
130
130
370
90
30
70
90

80
300
1,130
20
140
130
440
130
30
70
90

100
310
540
20
150
150
530
150
30
70
90

120
320
170
20
150
170
640
150
30
30
90

120
340
170
20
160
180
770
150
30
-20
90

130
340
170
20
170
200
920
150
30
-60
90

130
360
170
20
180
210
1,110
150
30
-60
90

600
1,670
1,220
100
810
1,170
3,970
750
150
-40
450

110

ANALYTICAL PERSPECTIVES

Table 6–5.

OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued
(In millions of dollars)
Outlay Equivalents
2001

21
22
23
24
25
26
27
28
29
30
31
32

33
34
35
36
37
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
77
78

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 .....................................................................................
Tax incentives for preservation of historic structures ............................................................................
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 ...............................................................................................
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) ...................
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 .......................................................................................
Transportation:
Deferral of tax on shipping companies ..................................................................................................
Exclusion of reimbursed employee parking expenses ..........................................................................
Exclusion for employer-provided transit passes ....................................................................................
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 ................................................................................
New markets tax credit ...........................................................................................................................
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 ..................................................................................................
Deduction for higher education expenses .........................................................................................
State prepaid tuition plans .................................................................................................................
Exclusion of interest on student-loan bonds .....................................................................................
Exclusion of interest on bonds for private nonprofit educational facilities .......................................

2002

2003

2004

2005

2006

2007

2003–2007

10
340
570
130
460
190

10
360
600
140
470
200

10
370
630
150
480
210

10
380
690
150
500
220

10
380
760
160
510
230

10
400
840
170
520
240

10
410
910
180
540
250

50
1,940
3,830
810
2,550
1,150

210
150
10
1,320
80
10

210
160
10
1,380
90
10

210
160
10
1,460
90
10

210
150
10
1,550
90
10

210
150
10
1,630
90
10

210
140
10
1,720
100
10

210
140
10
1,810
100
10

1,050
740
50
8,170
470
50

1,330
80
16,290
10
300
130

1,430
70
17,710
10
310
130

1,530
40
19,250
10
340
130

1,640
30
20,940
10
350
130

1,770
10
22,780
10
380
130

1,890
0
24,790
10
390
130

2,030
0
26,930
10
410
130

8,860
80
114,690
50
1,870
650

1,150
230
64,510
22,410
1,020
23,870
4,800
4,360
5,190

1,190
250
64,190
22,680
1,040
24,580
4,400
4,510
5,440

1,250
260
66,110
23,580
1,060
25,320
4,070
4,700
5,710

1,380
290
68,070
23,210
1,080
26,080
3,780
4,930
5,790

1,510
320
70,870
20,330
1,100
26,860
3,530
5,170
5,800

1,640
350
73,560
16,300
1,120
27,670
3,290
5,400
5,720

1,780
370
76,870
14,410
1,140
28,500
3,090
5,610
5,800

7,560
1,590
355,480
97,830
5,500
134,430
17,760
25,810
28,820

30
80
90,400
90
35,390
530
50
4,540
37,860
1,670
130
7,590
440

30
80
82,420
130
36,810
600
50
4,560
37,130
1,430
160
8,590
440

30
80
80,260
170
38,280
680
50
4,240
36,480
1,420
200
9,560
470

40
80
75,980
220
39,810
760
60
3,960
36,790
1,390
240
10,130
520

40
80
74,910
270
41,400
900
60
3,800
37,430
1,360
250
10,950
560

40
80
67,560
340
43,060
1,080
60
4,160
38,520
1,480
270
11,460
610

40
80
66,510
400
44,780
1,130
60
4,880
40,930
1,720
270
12,130
670

190
400
365,220
1,400
207,330
4,550
290
21,040
190,150
7,370
1,230
54,230
2,830

20
2,560
310

20
2,690
390

20
2,830
500

20
2,970
570

20
3,130
660

20
3,280
750

20
3,450
840

100
15,660
3,320

20
900
60
380
20
110

30
920
60
730
90
120

30
980
60
1,120
190
130

30
1,080
60
1,170
300
40

30
1,180
70
1,280
420
-20

30
1,280
70
1,410
610
-20

30
1,400
70
1,580
830
-20

150
5,920
330
6,560
2,350
110

1,330
5,300
3,030
40
460
0
250
330
770

1,320
5,270
2,940
60
540
560
340
330
780

1,330
4,510
3,030
90
760
2,940
430
340
830

1,360
3,690
4,020
150
790
3,790
510
370
920

1,460
3,760
3,830
260
810
4,760
590
410
1,010

1,520
3,500
3,520
390
840
3,860
680
440
1,090

1,530
3,720
3,800
550
850
0
760
510
1,190

7,200
19,180
18,200
1,440
4,050
15,350
2,970
2,070
5,040

111

6. TAX EXPENDITURES

Table 6–5.

OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued
(In millions of dollars)
Outlay Equivalents
2001

79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125

126
127
128
129
130
131
132
133
134
135
136

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 ...............................................................
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 ........................................................................................
Employer-provided child care .............................................................................................................
Assistance for adopted foster children ..............................................................................................
Adoption credit and exclusion ............................................................................................................
Exclusion of employee meals and lodging (other than military) ......................................................
Child credit 2 ........................................................................................................................................
Credit for child and dependent care expenses .................................................................................
Credit for disabled access expenditures ...........................................................................................
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 .............................................................................................
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 ...................................................................................................................................
401(k) plans ........................................................................................................................................
Individual Retirement Accounts ..........................................................................................................
Low and moderate income savers credit ..........................................................................................
Keogh plans ........................................................................................................................................
Exclusion of other employee benefits:
Premiums on group term life insurance ............................................................................................
Premiums on accident and disability insurance ................................................................................
Small business retirement plan credit ...............................................................................................
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 .................................................................................................................
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 .....................................................................
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 .................................................................................
General purpose fiscal assistance:
Exclusion of interest on public purpose State and local 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 ....................
Interest:
Deferral of interest on U.S. savings bonds ...........................................................................................

2002

2003

2004

2005

2006

2007

2003–2007

40
10
1,120
5,420
320

70
20
1,180
5,610
510

100
20
1,250
5,910
620

120
20
1,300
6,260
660

120
20
1,360
6,460
690

120
20
1,420
6,800
730

120
20
1,480
7,070
770

580
100
6,810
32,500
3,470

300
90
950
0
220
160
870
26,460
3,560
60
42,130
580
400

230
70
990
60
250
180
910
26,350
3,480
70
42,750
590
420

140
40
1,020
120
280
280
950
26,240
3,560
70
44,450
600
460

60
20
1,080
170
290
570
990
26,070
3,950
70
46,820
610
480

30
10
1,240
190
300
640
1,030
27,400
3,600
80
48,580
630
510

10
0
1,360
210
310
690
1,080
28,700
2,860
80
50,980
660
540

0
0
1,450
220
320
710
1,130
28,320
2,550
80
52,760
700
560

240
70
6,150
790
1,500
2,890
5,180
136,730
16,520
380
243,590
3,200
2,550

106,750
1,900
5,900
20
4,990
1,580
5,710
200
340

117,750
2,140
6,070
20
5,260
1,620
5,920
230
380

128,760
3,000
6,330
30
5,530
1,700
6,250
260
430

138,400
4,420
6,510
30
5,840
1,880
6,630
290
390

149,240
4,790
6,730
30
6,280
2,070
6,830
320
380

160,370
5,160
6,920
30
6,600
2,250
7,210
360
340

173,450
5,470
7,190
20
7,100
2,440
7,490
400
380

750,220
22,840
33,680
140
31,350
10,340
34,410
1,630
1,920

380
5,560
370
70
110

390
5,810
380
70
120

400
6,070
400
60
120

400
6,320
410
60
120

400
6,600
430
60
130

400
6,900
450
50
130

400
7,200
470
50
140

2,000
33,090
2,160
280
640

52,590
55,100
23,980
0
7,880

59,350
65,380
24,250
660
8,330

65,130
73,020
25,280
2,330
8,620

66,460
76,550
25,590
2,290
8,930

67,840
79,620
25,630
2,240
9,150

71,930
84,430
25,890
2,120
9,410

77,220
89,410
25,450
1,500
9,680

348,580
403,030
127,840
10,480
45,790

2,330
280
0
20
1,710
50
2,390
40
230
5,480

2,370
290
30
20
1,780
50
2,280
40
280
4,850

2,400
310
70
30
1,880
50
2,360
40
340
5,330

2,440
320
120
30
1,980
50
2,490
40
390
5,480

2,480
330
160
30
2,080
50
2,550
40
450
5,670

2,520
350
180
30
2,180
50
2,600
40
500
5,750

2,560
360
200
30
2,300
50
2,480
40
490
5,990

12,400
1,670
730
150
10,420
250
12,480
200
2,170
28,220

17,830
2,690
3,720

18,000
2,930
3,870

18,180
3,240
4,060

18,560
3,630
4,320

18,850
4,020
4,560

19,720
4,470
4,820

20,890
5,020
5,170

96,200
20,380
22,930

3,150
70
90
50

3,190
80
90
50

3,300
80
90
50

3,490
80
100
50

3,680
90
100
70

3,870
90
110
70

4,080
100
110
80

18,420
440
510
320

33,100
45,520
3,130

33,930
46,160
3,190

34,780
48,150
3,190

35,660
47,730
3,190

36,540
43,270
3,140

37,460
34,820
1,860

38,410
30,890
0

182,850
204,860
11,380

290

300

310

330

330

350

360

1,680

112

ANALYTICAL PERSPECTIVES

Table 6–5.

OUTLAY EQUIVALENT ESTIMATES FOR TAX EXPENDITURES IN THE INCOME TAX—Continued
(In millions of dollars)
Outlay Equivalents

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 State and local bonds for:
Public purposes ..................................................................................................................................
Energy facilities ...................................................................................................................................
Water, sewage, and hazardous waste disposal facilities .................................................................
Small-issues ........................................................................................................................................
Owner-occupied mortgage subsidies .................................................................................................
Rental housing ....................................................................................................................................
Airports, docks, and similar facilities .................................................................................................
Student loans ......................................................................................................................................
Private nonprofit educational facilities ...............................................................................................
Hospital construction ..........................................................................................................................
Veterans’ housing ...............................................................................................................................
Credit for holders of zone academy bonds ...........................................................................................

2001

2002

2003

2004

2005

2006

2007

2003–2007

22,410
45,520

22,680
46,160

23,580
48,150

23,210
47,730

20,330
43,270

16,300
34,820

14,410
30,890

97,830
204,860

33,100
130
570
440
1,150
230
900
330
770
1,580
50
40

33,930
130
600
440
1,190
250
920
330
780
1,620
50
70

34,780
150
630
470
1,250
260
980
340
830
1,700
50
100

35,660
170
690
520
1,380
290
1,080
370
920
1,880
50
120

36,540
180
760
560
1,510
320
1,180
410
1,010
2,070
70
120

37,460
200
840
610
1,640
350
1,280
440
1,090
2,250
70
120

38,410
210
910
670
1,780
370
1,400
510
1,190
2,440
80
120

182,850
1,170
3,830
2,830
7,560
1,590
5,920
2,070
5,040
10,340
320
580

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: 2001 $990; 2002 $1,020; 2003 $1,050; 2004 $1,080;
2005 $1,080; 2006 $1,100; and 2007 $1,120.
2 The figures in the table indicate the effect of the child tax credit on receipts. The effect of the credit on outlays (in millions of dollars) is as follows: 2001 $980; 2002 $7,390; 2003 $7,390; 2004 $7,210;
2005 $6,950; 2006 $9,380; and 2007 $9,200.
3 The figures in the table indicate the effect of the earned income tax credit on receipts. The effect of the credit on outlays (in millions of dollars) is as follows: 2001 $26,120; 2002 $28,280; 2003
$30,630; 2004 $31,080; 2005 $31,720; 2006 $33,130 and 2007 $34,090.

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 $10 million. Provisions with estimates that rounded to zero in each year are not included in the table.

Tax Expenditure Baselines
A tax expenditure is an exception to baseline provisions of the tax structure. The 1974 Congressional
Budget Act, which mandated the tax expenditure budget, did not specify the baseline provisions of the tax
law. As noted previously, deciding whether provisions
are 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 it is closer to existing
law. Tax expenditures under the reference law baseline
are generally tax expenditures under the normal tax
baseline, but 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 only when it is 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 owneroccupied 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).
Although 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;

6. TAX EXPENDITURES

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
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
2 Gross income does, however, include transfer paymnents 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 interst, 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. In addition, costs of earning income
may be limited under the alternative minimum tax.

113
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.
Performance Measures and the Economic
Effects of Tax Expenditures
The Government Performance and Results Act of
1993 (GPRA) directs Federal agencies to develop annual
and strategic plans for their programs and activities.
These plans set out performance objectives to be
achieved over a specific time period. Most of these objectives will be achieved through direct expenditure programs. Tax expenditures, however, may also contribute
to achieving these goals. The report of the Senate Governmental Affairs Committee on GPRA 4 calls on the
Executive branch to undertake a series of analyses to
assess the effect of specific tax expenditures on the
achievement of agencies’ performance objectives.
The Executive Branch is continuing to focus on the
availability of data needed to assess the effects of the
tax expenditures designed to increase savings. Treasury’s Office of Tax Analysis and Statistics of Income
Division (IRS) have developed a new sample of individual income tax filers as one part of this effort. This
new ‘‘panel’’ sample will follow the same taxpayers over
a period of at least ten years. The first year of this
panel sample was drawn from tax returns filed in 2000
for tax year 1999. The sample will capture the changing
demographic and economic circumstances of individuals
and the effects of changes in tax law over an extended
period of time. Data from the sample will therefore
permit more extensive, and better, analyses of many
tax provisions than can be performed using only annual
(‘‘cross-section’’) data. In particular, data from this
panel sample will enhance our ability to analyze the
effect of tax expenditures designed to increase savings.
Other efforts by OMB, Treasury, and other agencies
to improve data available for the analysis of savings
tax expenditures will continue over the next several
years.
Comparison of tax expenditure, spending, and
regulatory policies. Tax expenditures by definition
work through the tax system and, particularly, the income 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.
Because there is an existing public administrative and
private compliance structure for the tax system, the
4 Committee on Government Affairs, United States Senate, ‘‘Government Performance and
Results Act of 1993’’ (Report 103–58, 1993).

114
incremental administrative and compliance costs for a
tax expenditure may be low in many cases. In addition,
some tax expenditures actually simplify the tax system,
(for example, the exclusion for up to $500,000 of capital
gains on home sales). Tax expenditures also implicitly
subsidize certain activities. Spending, regulatory or taxdisincentive policies can also modify behavior, but may
have different economic effects. Finally, a variety of
tax expenditure tools can be used—e.g., deductions;
credits; exemptions; deferrals; floors; ceilings; phase-ins;
phase-outs; 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 economic effects.
Tax expenditures also have limitations. In many
cases they add to the complexity of the tax system,
which raises both administrative and compliance costs.
For example, targeting personal exemptions and credits
can complicate filing and decisionmaking. The income
tax system may have little or no contact with persons
who have no or very low incomes, and does not require
information on certain characteristics of individuals
used in some spending programs, such as wealth. 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 activities to be addressed with specific resources in a way that is difficult to emulate
with tax expenditures. Finally, tax expenditures may
not receive the same level of scrutiny afforded to other
programs.
Outlay programs 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 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 tax 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,
which can impose further costs by diverting resources
from their most efficient uses. Finally, spending programs, particularly on the discretionary side, may respond less readily to changing activity levels and economic conditions than tax expenditures.

ANALYTICAL PERSPECTIVES

Regulations have more direct and immediate effects
than outlay and tax-expenditure programs because regulations apply directly and immediately to the regulated party (i.e., the intended actor)—generally in the
private sector. Regulations can also be fine-tuned more
quickly than tax expenditures, because they can generally be changed by the executive branch without legislation. Like tax expenditures, regulations often rely
largely 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, although
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 Federal outlays or receipts. Thus,
like tax expenditures, they may escape the type of scrutiny that outlay programs receive. However, most regulations are subjected to a formal benefit-cost analysis
that goes well beyond the analysis required for outlays
and tax-expenditures. To some extent, the GPRA requirement for performance evaluation will address this
lack of formal analysis.
Some policy objectives are achieved using multiple
approaches. For example, minimum wage legislation,
the earned income tax credit, and the food stamp program are regulatory, tax expenditure, and direct outlay
programs, respectively, all having the objective of improving the economic welfare of low-wage workers.
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., the exclusion for up to $500,000 of capital gains on home sales); 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,
accelerated depreciation may encourage investment. 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 revenue
effect. Outputs are quantitative or qualitative measures
of goods and services, or changes in income and investment, directly produced by these inputs. Outcomes, in

6. TAX EXPENDITURES

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). Effects on the incomes of
members of particular groups 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 provisions. In
addition, such assessments can raise significant challenges in economic modeling.
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 goals such as tax neutrality. These include
the exclusion for income earned abroad by nongovernmental employees and exclusions for income of U.S.controlled foreign corporations. Measuring the effectiveness of these provisions raises challenging issues.
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 ac-

115
tivities—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 (e.g., research spending, exploration activity, equipment) might 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 size of tax expenditures.
Measures could also indicate the 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 increase production (as
opposed to benefitting existing output) and their costeffectiveness 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. The mortgage interest deduction on personal residences is a tax expenditure because the value of owneroccupied housing services is not included in a taxpayer’s
taxable income. Taxpayers also may exclude up to
$500,000 of the capital gains from the sale of personal
residences. 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 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 estimates reflect the cost

116

ANALYTICAL PERSPECTIVES

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 employer-provided 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.

Other provisions principally affect the incomes of
members of certain groups, rather than affecting incentives. 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 earned-income tax credit,
in contrast, should be evaluated for its effects on labor
force participation as well as the income it provides
lower-income workers.

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 grants and other policies designed
to spur economic development.

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
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, although broad, is
nevertheless incomplete, omitting important details
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. As indicated
above, over the next few years the Executive Branch’s
focus will be on the availability of the data needed
to assess the effects of the tax expenditures designed
to increase savings.

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
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 pooling of risks. 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.
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). 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 value of benefits funded at the firm level to individuals.

Descriptions of Income Tax Provisions
Descriptions of the individual and corporate income
tax expenditures reported upon in this chapter follow.
These descriptions relate to current law as of December
31, 2001, and do not reflect proposals made elsewhere
in the Budget.
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.—U.S. citizens who lived
abroad, worked in the private sector, and satisfied a
foreign residency requirement in 2001 may exclude up
to $78,000 in foreign earned income from U.S. taxes.

117

6. TAX EXPENDITURES

The exclusion increases to $80,000 in 2002 (and thereafter). In addition, if these taxpayers receive a specific
allowance for foreign housing from their employers,
they may also exclude the value of that allowance. If
they do not receive a specific allowance for housing
expenses, they may deduct against their U.S. taxes that
portion of such expenses that exceeds one-sixth the salary of a civil servant at grade GS–14, step 1 ($67,765
in 2001).
3. Exclusion of certain allowances for Federal
employees abroad.—U.S. Federal civilian employees
and Peace Corps members who work outside the continental United States are allowed to exclude from U.S.
taxable income certain special allowances they receive
to compensate them for the relatively high costs associated with living overseas. The allowances supplement
wage income and cover expenses like rent, education,
and the cost of travel to and from the United States.
4. Extraterritorial income exclusion 5.—For purposes of calculating U.S. tax liability, a taxpayer may
exclude from gross income the qualifying foreign trade
income attributable to foreign trading gross receipts.
The exclusion generally applies to income from the sale
or lease of qualifying foreign trade property and certain
types of services income. The FSC Repeal and
Extraterritorial Income Exclusion Act of 2000 created
the extraterritorial income exclusion to replace the foreign sales corporation provisions, which the Act repealed. The exclusion is generally available for transactions entered into after September 30, 2000.
5. 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.
6. 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
pre-tax income from such a controlling interest is considered to be 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.
7. Exceptions under subpart F for active financing income.—Financial firms can defer taxes on income earned overseas in an active business. Taxes on
5 The determination of whether a provision is a tax expenditure is made on the basis
of a broad concept of ‘‘income’’ that is larger in scope than is ‘‘income’’ as defined under
general U.S. income tax principles. For that reason, the tax expenditure extimates include,
for example, estimtes related to the exclusion of extraterritorial income, as well as other
exclusions, notwithstanding that such exclusions define income under the general rule of
U.S. income taxation.

income earned through December 31, 2001 can be deferred.
General Science, Space, and Technology
8. 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.
9. R&E credit.—The research and experimentation
(R&E) credit is 20 percent of qualified research expenditures in excess of a base amount. The base amount
is generally determined by multiplying a ‘‘fixed-base
percentage’’ by the average amount of the company’s
gross receipts for the prior four years. The taxpayer’s
fixed base percentage generally is the ratio of its research expenses to gross receipts for 1984 through
1988. Taxpayers may also elect an alternative credit
regime. Under the alternative credit regime the taxpayer is assigned a three-tiered fixed-base percentage
that is lower than the fixed-base percentage that would
otherwise apply, and the credit rate is reduced (the
rates range from 2.65 percent to 3.75 percent). A 20percent credit with a separate threshold is provided
for a taxpayer’s payments to universities for basic research. The credit applies to research conducted before
July 1, 2004 and extends to research conducted in Puerto Rico and the U.S. possessions.
Energy
10. 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.
11. 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

118
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.
12. Alternative fuel production credit.—A nontaxable credit of $3 per oil-equivalent barrel of production (in 1979 dollars) 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.
13. 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.
14. Capital gains treatment of royalties on
coal.—Sales of certain coal under royalty contracts can
be treated as capital gains rather than ordinary income.
15. 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.
16. 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
include tertiary injectant expenses, intangible drilling
and development costs on a qualified enhanced oil recovery project, and amounts incurred for tangible depreciable property.
17. 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, biomass, and poultry
waste facilities. The renewable resources credit applies
only to electricity produced by a facility placed in service on or before December 31, 2001.
18. Alcohol fuel credits.—An income tax credit is
provided for ethanol that is derived from renewable
sources and used as fuel. The credit equals 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.
19. 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

ANALYTICAL PERSPECTIVES

part of their expenditures. The credit and deduction
are phased out from 2002 through 2005.
20. Exclusion of utility conservation subsidies.—
Non-business customers can exclude from gross income
subsidies received from public utilities for expenditures
on energy conservation measures.
Natural Resources and Environment
21. 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.
22. Percentage depletion.—Most nonfuel mineral
extractors may use percentage depletion rather than
cost depletion, with percentage depletion rates ranging
from 22 percent for sulfur to 5 percent for sand and
gravel.
23. Sewage, water, solid and hazardous waste
facility 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.
24. Capital gains treatment of certain timber.—
Certain timber sold under a royalty contract can be
treated as a capital gain rather than ordinary income.
25. 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
costs are capitalized under the uniform capitalization
rules.
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, a debtor must include the amount of loan forgiveness as income or reduce his recoverable basis in

6. TAX EXPENDITURES

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 reduces carryover losses,
then unused credits, and then basis; any remainder
of the forgiven debt is excluded from tax. 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.—Taxpayers can
lower their tax liability by averaging, over the prior
three-year period, their taxable income from farming.
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.
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 $2.1 million 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

119
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.
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 these and other private
activity is limited. The combined volume cap for private
activity bonds, including mortgage housing bonds, rental housing bonds, student loan bonds, and industrial
development bonds is $62.50 per capita ($187.5 million
minimum) per State in 2001, and $75 per capita ($225
million minimum) in 2002. The Community Renewal
Tax Relief Act of 2000 accelerated the scheduled increase in the state volume cap and indexed the cap
for inflation, beginning in 2003. 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 value of owner-occupied housing services is not included in a taxpayer’s taxable 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

120
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 who 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
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 million
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. The Community Renewal Tax Relief Act of
2000 increased the per-resident limit to $1.50 in 2001
and to $1.75 in 2002 and indexed the limit for inflation,
beginning in 2003. The Act also created a $2 million
minimum annual cap for small States beginning in
2002; the cap is indexed for inflation, beginning in
2003.
47. Accelerated depreciation of rental property.—
The tax depreciation allowance provisions are part of
the reference law rules, and thus do not give rise to
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, a 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 inter-

ANALYTICAL PERSPECTIVES

est 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. 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 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 most assets held for more than 1 year, the top
capital gains tax rate is 20 percent. For assets acquired
after December 31, 2000, the top capital gains tax rate
for assets held for more than 5 years is 18 percent.
On January 1, 2001, taxpayers may mark-to-market
existing assets to start the 5-year holding period. Losses
from the mark-to-market are not recognized.
For assets held for more than 1 year by taxpayers
in the 15-percent ordinary tax bracket, the top capital
gains tax rate is 10 percent. After December 31, 2000,
the top capital gains tax rate for assets held by these
taxpayers for more than 5 years is 8 percent.
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. After repeal
of the estate tax under EGTRRA for 2010, the basis
for property acquired from a decedent will be the lesser
of fair market value or the decedent’s basis. Certain
types of additions to basis will be allowed so that assets
in most estates that are not currently subject to estate
tax will not be subject to capital gains tax in the hands
of the heirs.
53. Carryover basis of capital gains on gifts.—
When a gift is made, the donor’s basis in the transferred property (the cost that was incurred when the
transferred property was first acquired) carries-over to
the donee. The carryover of the donor’s basis allows
a continued deferral of unrealized capital gains. Even
though the estate tax is repealed for 2010 under
EGTRRA, the gift tax is retained with a lifetime exemption of $1 million.

121

6. TAX EXPENDITURES

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 give rise to 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.
56. Accelerated depreciation of machinery and
equipment.—The tax depreciation allowance provisions
are part of the reference law rules, and thus do not
give rise to tax expenditures under reference law.
Under the normal tax baseline, this tax depreciation
allowance is measured relative to straight-line depreciation using Asset Depreciation Range (ADR) lives. Statutory depreciation of machinery and equipment is accelerated relative to this baseline, thereby creating a tax
expenditure under the normal tax rules.
57. Expensing of certain small investments.—In
2001, qualifying investments in tangible property up
to $24,000 can be expensed rather than depreciated
over time. The expensing limit increases to $25,000
in 2003. To the extent that qualifying investment during the year exceeds $200,000, the amount eligible for
expensing is decreased. In 2001, the amount expensed
is completely phased out when qualifying investments
exceed $224,000.
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 $75,000. 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.
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 employee parking expenses.—
Employee parking expenses that are paid for by the
employer or that are received in lieu of wages are excludable from the income of the employee. In 2001,
the maximum amount of the parking exclusion is $180
(indexed) per month. The tax expenditure estimate does
not include parking at facilities owned by the employer.
63. Exclusion of employee transit pass expenses.—Transit passes, tokens, fare cards, and vanpool expenses paid for by an employer or provided in
lieu of wages to defray an employee’s commuting costs
are excludable from the employee’s income. In 2001,
the maximum amount of the exclusion is $65 (indexed)
per month. In 2002, the maximum amount of the exclusion increases to $100 (indexed) 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.

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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, enterprise communities,
and renewal 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, accelerated depreciation, and certain
capital gains incentives. In addition, certain first-time
buyers of a principal residence in the District of Columbia can receive a tax credit on homes purchased on
or before December 31, 2003, and investors in certain
D.C. property can receive a capital gains break. The
Community Renewal Tax Relief Act of 2000 created
the renewal communities tax benefits, which begin on
January 1, 2002 and expire on December 31, 2009.
The Act also created additional empowerment zones,
increased the tax benefits for empowerment zones, and
extended the expiration date of (1) empowerment zones
from December 31, 2004 to December 31, 2009, and
(2) the D.C. home-buyer credit from December 31, 2001
to December 31, 2003.
68. New markets tax credit.—Taxpayers who invest
in a community development entity (CDE) after December 31, 2000 are eligible for a tax credit. The total
equity investment available for the credit across all
CDEs is $1.0 billion in 2001, $1.5 billion in 2002 and
2003, $2.0 billion in 2004 and 2005, and $3.5 billion
in 2006 and 2007. The amount of the credit equals
(1) 5 percent in the year of purchase and the following
2 years, and (2) 6 percent in the following 4 years.
A CDE is any domestic firm whose primary mission
is to serve or provide investment capital for low-income
communities/individuals; a CDE must be accountable
to residents of low-income communities. The Community Renewal Tax Relief Act of 2000 created the new
markets tax credit.
69. Expensing of environmental remediation
costs.—Taxpayers who clean up certain 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. The expensing only applies to clean-up costs
incurred on or before December 31, 2003. The Community Renewal Tax Relief Act of 2000 extended the expiration date from December 31, 2001 to December 31,
2003. The Act also expanded the number of qualified
sites.
Education, Training, Employment, and Social
Services
70. 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 fami-

ANALYTICAL PERSPECTIVES

lies 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).
71. 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) (indexed beginning in 2002).
72. 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 before January 1, 2003, 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) (indexed beginning in 2002). The credit applies to both undergraduate and graduate students.
73. Deduction for higher education expenses.—
EGTRRA provides a new above-the-line deduction for
qualified higher education expenses. The maximum annual deduction is $3,000 beginning in 2002 for taxpayers with adjusted gross income up to $130,000 on
a joint return ($65,000 for singles). The maximum deduction increases to $4,000 in 2004. Taxpayers with
adjusted gross income up to $160,000 on a joint return
($80,000 for singles) may deduct up to $2,000 beginning
in 2004. No deduction is allowed for expenses paid after
December 31, 2005.
74. 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 in 2001 is $500 per beneficiary. In 2001, 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). EGTRRA increases the maximum contribution to
$2,000 and the phase-out range for joint filers to
$190,000 through $220,000 of modified AGI, double the
range of singles. EGTRRA also allows elementary and
secondary school expenses to be paid tax-free from such
accounts.

6. TAX EXPENDITURES

75. Student-loan interest.—Taxpayers may claim
an above-the-line deduction of up to $2,500 on interest
paid on an education loan. Interest may only be deducted for the first five years in which interest payments are required. In 2001, 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). EGTRRA increased the income thresholds
for the phase down to $100,000 and $130,000 ($50,000
and $65,000 for singles) (indexed) and repealed the five
year rule for interest payments made after December
21, 2001.
76. 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. In
2001 taxes on the earnings from these plans are paid
by the beneficiaries and are deferred until tuition is
actually paid. Beginning in 2002, investment income
is not taxed when earned, and is tax-exempt when
withdrawn to pay for qualified expenses. These changes
were the result of EGTRRA.
77. 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.
78. 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.
79. Credit for holders of zone academy bonds.—
Financial institutions that own zone academy bonds
receive a non-refundable tax credit (at a rate set by
the Treasury Department) rather than interest. The
credit is included in gross income. Proceeds from zone
academy bonds may only be used to renovate, but not
construct, qualifying schools and for certain other
school purposes. The total amount of zone academy
bonds that may be issued is limited to $1.6 billion—
$400 million in each year from 1998 to 2001.
80. 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 $83,650 and $113,650 ($55,750 and
$70,750 for singles) in 2001.
81. 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.
82. 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 chari-

123
table 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.
83. 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. EGTRRA permanently extended this exclusion and extended the exclusion to also include graduate education (beginning in 2002).
84. Work opportunity tax credit.—Employers can
claim a tax credit for qualified wages paid to individuals who begin work on or before December 31, 2001
and who are certified as members of various targeted
groups. The amount of the credit that can be claimed
is 25 percent for employment of less than 400 hours
and 40 percent for employment of 400 hours or more.
The maximum credit per employee is $2,400 and can
only be claimed on the first year of wages an individual
earns from an employer. Employers must reduce their
deduction for wages paid by the amount of the credit
claimed.
85. 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
on or before December 31, 2001.
86. Employer-provided child care exclusion.—
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.
87. Employer-provided child care credit.—Employers can deduct expenses for supporting child care
or child care resource and referral services. EGTRRA
provides a tax credit to employers for qualified expenses
beginning in 2002. The credit is equal to 25 percent
of qualified expenses for employee child care and 10
percent of qualified expenses for child care resource
and referral services. Employer deductions for such expenses are reduced by the amount of the credit. The
maximum total credit is limited to $150,000 per taxable
year.
88. Assistance for adopted foster children.—Taxpayers who adopt eligible children from the public foster care system can receive monthly payments for the
children’s significant and varied needs and a reimbursement of up to $2,000 for nonrecurring adoption expenses. These payments are excluded from gross income.
89. 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) for 2001. The credit
is phased-out ratably for taxpayers with modified AGI

124
between $75,000 and $115,000 in 2001. EGTRRA increased the maximum credit for non-special needs children to $10,000, set a flat credit amount of $10,000
for special needs children, and increased the start point
of the phase-out to $150,000 beginning in 2002. The
credit amounts and the phase-out thresholds are indexed for inflation beginning in 2003. Unused credits
may be carried forward and used during the five subsequent years. Taxpayers may also exclude qualified
adoption expenses from income, subject to the same
maximum amounts and phase-out as the credit. The
same expenses cannot qualify for tax benefits under
both programs; however, a taxpayer may use the benefits of the exclusion and the tax credit for different
expenses. Stepchild adoptions are not eligible for either
benefit. Both the credit and the exclusion were made
permanent by EGTRRA.
90. 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.
91. Child credit.—Taxpayers with children under
age 17 can qualify for a $600 refundable per child credit. The maximum credit is increased to $700 in 2005,
$800 in 2009, and $1,000 in 2010. 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).
92. 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 single parents and
by divorced or separated parents who have custody of
children. Expenditures up to a maximum $2,400 for
one dependent and $4,800 for two or more dependents
are eligible for the credit. EGTRRA increased the maximum expenditure limit to $3,000 for one dependent
and $6,000 for two or more dependents beginning in
2003. The credit is equal to 30 percent of qualified
expenditures (35 percent beginning in 2003) for taxpayers with incomes of $10,000 or less ($15,000 or less
beginning in 2003). The credit is reduced to a minimum
of 20 percent by one percentage point for each $2,000
of income in excess of $10,000 ($15,000 beginning in
2003).
93. 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.
94. 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

ANALYTICAL PERSPECTIVES

income; a corporation’s total charitable contributions
generally may not exceed 10 percent of pre-tax income.
95. 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.
96. 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
97. 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.
98. 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 60 percent in 2001, 70 percent in
2002, and 100 percent in 2003 and thereafter.
99. 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.
100. 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, 2002.
The Community Renewal Tax Relief Act of 2000 extended the expiration date from December 31, 2000
to December 31, 2002.
101. 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.
102. Hospital construction bonds.—Interest earned
on State and local government debt issued to finance

6. TAX EXPENDITURES

hospital construction is excluded from income subject
to tax.
103. 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.
104. 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.
105. 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
106. 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.
107. Workers’ compensation benefits.—Workers
compensation provides payments to disabled workers.
These benefits, although income to the recipients, are
not subject to the income tax.
108. 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.
109. 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.
110. Military disability pensions.—Most of the
military pension income received by current disabled
retired veterans is excluded from their income subject
to tax.
111. 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.
112. 401(k) plans.—Individual taxpayers can make
tax-preferred contributions to certain types of employerprovided 401(k) plans (and 401(k)-type plans like 403(b)
plans and the Federal government’s Thrift Savings
Plan). In 2001, an employee could exclude up to $10,500
(indexed) of wages from AGI under a qualified arrangement with an employer’s 401(k) plan. EGTRRA increases the exclusion amount to $11,000 in 2002,
$12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and

125
$15,000 in 2006 (indexed thereafter). The tax on the
investment income earned by 401(k)-type plans is deferred until withdrawn.
EGTRRA also allows employees to make after-tax
contributions to 401(k) and 401(k)-type plans beginning
in 2002. These contributions are not excluded from AGI,
but the investment income of such after-tax contributions is not taxed when earned or withdrawn.
113. Individual Retirement Accounts.—Individual
taxpayers can take advantage of several different Individual Retirement Accounts (IRAs): deductible IRAs,
non-deductible IRAs, and Roth IRAs. In 2001, employees can make annual contributions to an IRA up to
$2,000 (or 100 percent of compensation, if less). The
annual contributions limit applies to the total of a taxpayer’s deductible, non-deductible, and Roth IRAs contributions. EGTRRA increases the IRA contribution
limit to $3,000 in 2002, $4,000 in 2005, and $5,000
in 2008 (indexed thereafter) and allows taxpayers over
age 50 to make additional ‘‘catch-up’’ contributions of
$1,000 (by 2006).
Taxpayers whose AGI is below $53,000 ($33,000 for
non-joint filers) in 2001 can claim a deduction for IRA
contributions. In 2001, the IRA deduction is phased
out for taxpayers with AGI between $53,000 and
$63,000 ($33,000 and $43,000 for non-joint). The phaseout range increases annually until it reaches $80,000
to $100,000 in 2007 ($50,000 to $60,000 in 2005 for
non-joint filers). Taxpayers whose AGI is above the
phase-out range can also claim a deduction for their
IRA contributions depending on whether they (or their
spouse) are an active participant in an employer-provided retirement plan. The tax on the investment income earned by 401(k) plans, non-deductible IRAs, and
deductible IRAs is deferred until the money is withdrawn.
Taxpayers with incomes below $150,000 ($90,000 for
nonjoint filers) can make contributions to Roth IRAs.
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). Investment
income of a Roth IRA is not taxed when earned nor
when withdrawn. Withdrawals from a Roth IRA are
penalty 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.
Taxpayers can contribute to a non-deductible IRA regardless of their income and whether they are an active
participant in an employer-provided retirement plan.
The tax on investment income earned by non-deductible
IRAs is deferred until the money is withdrawn.
114. Low and moderate income savers’ credit.—
EGTRRA provides an additional incentive for lowerincome taxpayers to save through a nonrefundable credit of up to 50 percent on IRA contributions. This credit
is in addition to any deduction or exclusion. The credit
is completely phased out by $50,000 for joint filers and
$25,000 for single filers. This temporary credit is in
effect from 2002 through 2006.

126
115. 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 $35,000 in 2001. Total plan contributions are limited to 15 percent of a firm’s total wages.
EGTRRA increases the percent of pay limit to 100 percent of the income of the self-employed by 2005 and
increases the dollar limit on contributions to $40,000
beginning in 2002. EGTRRA also increased the plan
limit to 25 percent of a firm’s total wages and excluded
employee contributions from this limit beginning in
2002. The tax on the investment income earned by
Keogh plans is deferred until withdrawn.
116. 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.
117. Small business retirement plan credit.—
EGTRRA provides businesses with 100 or fewer employees a credit for 50 percent of the qualified startup costs
associated with a new qualified retirement plan. The
credit is limited to $500 annually and may only be
claimed for expenses incurred during the first three
years from the start of the qualified plan. Qualified
startup expenses include expenses related to the establishment and administration of the plan, and the retirement-related education of employees. The credit applies
to costs incurred beginning in 2002.
118. 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.
119. Employer-provided supplementary unemployment benefits.—Employers may establish trusts
to pay supplemental unemployment benefits to employees separated from employment. Interest payments to
such trusts are exempt from taxation.
120. 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.

ANALYTICAL PERSPECTIVES

121. Additional deduction for the blind.—Taxpayers who are blind may take an additional $1,100
standard deduction if single, or $900 if married.
122. Additional deduction for the elderly.—Taxpayers who are 65 years or older may take an additional $1,100 standard deduction if single, or $900 if
married.
123. 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
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.
124. 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.
125. 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 $7,140 of earned income in 2001. The credit
is 40 percent of the first $10,020 of income for a family
with two or more qualifying children. The credit is
phased out beginning when the taxpayer’s income exceeds $13,090 at the rate of 15.98 percent (21.06 percent if two or more qualifying children are present).
It is completely phased out when the taxpayer’s modified adjusted gross income reaches $28,281 ($32,121 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 2001,
the credit is 7.65 percent of the first $4,760 of earned
income. When the taxpayer’s income exceeds $5,950,
the credit is phased out at the rate of 7.65 percent.
It is completely phased out at $10,710 of modified adjusted gross income.
For workers with or without children, the income
levels at which the credit begins to phase-out and the
maximum amounts of income on which the credit can
be taken are adjusted for inflation. For married taxpayers filing a joint return, EGTRRA increases the base
amount for the phase-out by $1,000 in 2002 through
2004, $2,000 in 2005 through 2007, and $3,000 in 2008
(indexed thereafter). 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

127

6. TAX EXPENDITURES

amount that offsets tax liabilities is shown as a tax
expenditure.
Social Security
126. 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.
127. Social Security benefits for the disabled.—
Benefit payments from the Social Security Trust Fund,
for disability and for dependents and survivors, are excluded from a beneficiary’s gross incomes.
128. Social Security benefits for dependents and
survivors.—Benefit payments from the Social Security
Trust Fund for dependents and survivors are excluded
from a beneficiary’s gross income.
Veterans Benefits and Services
129. Veterans death benefits and disability compensation.—All compensation due to death or disability paid by the Veterans Administration is excluded
from taxable income.

130. Veterans pension payments.—Pension payments made by the Veterans Administration are excluded from gross income.
131. G.I. Bill benefits.—G.I. Bill benefits paid by
the Veterans Administration are excluded from gross
income.
132. 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
133. 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), equipment acquisition, and
other public purposes is tax-exempt. Interest on bonds
issued by Indian tribal governments for essential governmental purposes is also tax-exempt.
134. 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.
135. Business income earned in U.S. possessions.—U.S. corporations operating in a U.S. possession
(e.g., Puerto Rico) can claim a credit against some or
all of their U.S. tax liability on possession business
income. The credit expires December 31, 2005.
Interest
136. U.S. savings bonds.—Taxpayers may defer paying tax on interest earned on U.S. savings bonds until
the bonds are redeemed.

SPECIAL ANALYSES AND PRESENTATIONS

129

7.

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. An Administration proposal for
capital acquisition funds that is being developed is dis-

cussed in Chapter 1, ‘‘Budget and Performance Integration,’’ in this volume.
In this chapter, investments are discussed in the following sections:
• a description of the size and composition of Federal investment spending;
• 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.

Part I: DESCRIPTION OF FEDERAL INVESTMENT
For more than fifty years, the Federal budget has
included a chapter on Federal investment—defined as
those outlays that yield long-term benefits—separately
from outlays for current use. In recent years 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
2007.
The classification of spending between investment
and current outlays is a matter of judgment. The budget has historically employed a relatively broad classification, encompassing 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 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 de-

fense 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 include 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
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

131

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ANALYTICAL PERSPECTIVES

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 or education and
training. For more information about the treatment of
Federal credit programs, refer to Chapter 25, ‘‘Budget
System and Concepts and Glossary.’’
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 7–1. 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 $292.6
billion in 2001. They are estimated to increase to $324.6
billion in 2002 and are projected to increase further
to $342.6 billion in 2003. Major Federal investment
outlays will comprise an estimated 16.1 percent of total
Federal outlays in 2003 and 3.1 percent of the Nation’s
gross domestic product (GDP). Greater detail on Federal investment is available in Tables 7–2 and 7–3 at
the end of this Part. Those tables include both budget
authority and outlays.
Physical investment.—Outlays for major public physical capital investment (hereafter referred to as physical
investment outlays) are estimated to be $159.6 billion
in 2003. Physical investment outlays are for construction and rehabilitation, the purchase of major equipment, and the purchase or sale of land and structures.
More than three-fifths of these outlays are for direct
physical investment by the Federal Government, with
the remainder 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 are estimated to increase from $69.1 billion in 2002 to $72.6 billion in
2003. Almost all of these outlays, or an estimated $63.7
billion in 2003, 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.
Outlays for direct physical investment for nondefense
purposes are estimated to be $29.8 billion in 2003.
These outlays include $17.7 billion for construction and
rehabilitation. This amount includes funds for water,
power, and natural resources projects of the Corps of
Engineers, the Bureau of Reclamation within the De-

partment 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; facilities for
space and science programs, and Indian Health Service
hospitals and clinics. Outlays for the acquisition of
major equipment are estimated to be $11.7 billion in
2003. The largest amounts are for the air traffic control
system. For the purchase or sale of land and structures,
disbursements are estimated to exceed collections by
$0.4 billion in 2003. These purchases are largely for
buildings and land for parks and other recreation purposes.
Grants to State and local governments for physical
investment are estimated to be $57.2 billion in 2003.
Almost two-thirds of these outlays, or $37.4 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 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. More than half of these outlays are for
national defense. Physical investment for research and
development facilities and equipment is included in the
physical investment category.
Nondefense outlays for the conduct of research and
development are largely for the space programs, the
National Science Foundation, the National Institutes
of Health, and research for nuclear and non-nuclear
energy programs.
A more complete and detailed discussion of research
and development funding appears in Chapter 8, ‘‘Research and Development Funding,’’ in this volume.
Conduct of education and training.—Outlays for the
conduct of education and training are estimated to be
$76.1 billion in 2003. These outlays add to the stock

7.

133

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–1.

COMPOSITION OF FEDERAL INVESTMENT OUTLAYS
(In billions of dollars)
2001
Actual

Estimate
2002

2003

Federal Investment
Major public physical capital investment:
Direct Federal:
National defense ...................................................................................................
Nondefense ..........................................................................................................

63.7
27.8

69.1
31.5

72.6
29.8

Subtotal, direct major public physical capital investment ....................................
Grants to State and local governments ...............................................................

91.4
53.4

100.6
56.8

102.4
57.2

Subtotal, major public physical capital investment ..............................................
Conduct of research and development:
National defense ..................................................................................................
Nondefense ..........................................................................................................

144.8

157.4

159.6

48.4
38.0

54.3
42.9

59.9
47.0

Subtotal, conduct of research and development .................................................

86.4

97.3

106.9

34.8
26.5

40.2
29.6

45.5
30.5

Subtotal, conduct of education and training ........................................................

61.3

69.9

76.1

Total, major Federal investment outlays ..................................................................

292.6

324.6

342.6

MEMORANDUM
Major Federal investment outlays:
National defense ..................................................................................................
Nondefense ..........................................................................................................

112.1
180.4

123.5
201.1

132.6
210.0

Total, major Federal investment outlays .....................................................................
Miscellaneous physical investments:
Commodity inventories ........................................................................................
Other physical investment (direct) ......................................................................

292.6

324.6

342.6

1.5
3.8

0.4
4.3

*
4.5

Total, miscellaneous physical investment ...................................................................

5.4

4.7

4.5

297.9

329.3

347.1

Conduct of education and training:
Grants to State and local governments .............................................................
Direct Federal ......................................................................................................

Total, Federal investment outlays, including miscellaneous physical investment .......
* Indicates $50 million or less.

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 $45.5 billion
in 2003, almost 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 Federal education and training outlays are estimated to be $30.5 billion in 2003. 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 7–1. These
items, all for physical investment, are generally unrelated to improving Government operations or enhancing
economic activity.
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. Purchases are
estimated to exceed sales by $28 million in 2003.
Outlays for other miscellaneous physical investment
are estimated to be $4.5 billion in 2003. This category
includes primarily conservation programs. These are
entirely direct Federal outlays.

134

ANALYTICAL PERSPECTIVES

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 2007. Table 7–2 displays budget authority (BA) and
outlays (O) by major programs according to defense

and nondefense categories. The greatest level of detail
appears in Table 7–3, 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.

7.

135

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–2. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: DEFENSE AND NONDEFENSE PROGRAMS
(in millions of dollars)

2001
Actual

Description
NATIONAL DEFENSE
Major public physical investment:
Construction and rehabilitation ....................................................................

Estimate
2002

2003

2004

2005

2006

2007

BA
O
Acquisition of major equipment ................................................................... BA
O
Purchase or sale of land and structures .................................................... BA
O

8,163
7,452
63,789
56,237
–14
–21

10,082
8,218
63,103
60,907
–4
–9

8,416
8,947
70,414
63,708
–14
–12

9,503
8,815
76,277
66,824
–31
–31

10,740
8,592
80,747
76,580
–31
–31

15,232
9,558
88,476
83,331
–31
–31

18,216
11,939
100,533
89,141
–31
–31

Subtotal, major public physical investment ............................................ BA
O

71,938
63,668

73,181
69,116

78,816
72,643

85,749
75,608

91,456
85,141

103,677
92,858

118,718
101,049

Conduct of research and development ........................................................... BA
O
Conduct of education and training (civilian) .................................................... BA
O

49,713
48,444
7
7

57,855
54,346
8
8

62,983
59,939
8
8

66,227
61,467
8
8

69,954
65,453
8
8

68,279
66,931
8
8

67,427
66,825
8
8

BA
O

121,658
112,119

131,044
123,470

141,807
132,590

151,984
137,083

161,418
150,602

171,964
159,797

186,153
167,882

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

34,564
27,207
7,210
6,760
53
15
2,611
2,024
5,112
4,939
2,424
1,684
4,307
4,214
5,084
4,542
7,319
7,220
1,426
1,436
1,398
1,297
327
1,039
1,184
959
10,355
6,258

35,136
28,843
6,576
6,222
21
20
3,193
2,816
7,000
5,235
1,775
1,909
4,144
3,902
4,415
4,634
7,273
7,644
1,990
1,981
1,866
1,684
851
612
1,545
1,325
8,164
8,240

30,716
27,808
6,915
6,330
21
53
3,432
3,298
4,732
5,878
1,685
1,933
3,804
4,130
3,902
4,284
7,092
7,706
1,271
1,272
1,991
1,686
1,331
1,039
1,543
1,298
6,032
6,937

26,336
24,880
7,059
6,425
21
43
3,490
3,433
4,831
6,526
1,722
1,790
3,883
4,255
3,970
4,042
7,241
8,093
1,357
1,359
2,029
1,802
983
1,080
1,575
1,336
6,069
6,831

31,775
24,054
7,218
6,457
22
22
3,553
3,528
4,938
5,472
1,758
1,783
3,970
4,244
4,338
4,188
7,402
8,124
1,760
1,762
2,072
1,876
1,114
1,070
1,610
1,388
6,210
6,609

32,365
24,271
7,386
6,408
22
24
3,620
3,640
5,053
4,950
1,800
1,729
3,160
4,222
4,201
4,314
7,575
8,614
1,385
1,386
2,120
1,922
1,048
1,103
1,648
1,420
6,352
6,562

32,966
24,662
7,559
7,106
23
22
3,689
3,718
5,171
5,014
1,843
1,787
3,234
4,142
4,293
4,315
7,751
7,672
1,316
1,318
2,170
1,969
1,532
1,267
1,687
1,449
6,493
6,662

BA
O

83,374
69,594

83,949
75,067

74,467
73,652

70,566
71,895

77,740
70,577

77,735
70,565

79,727
71,103

Acquisition of major equipment:
Air transportation ..................................................................................... BA
O
Postal Service .......................................................................................... BA
O
Other ........................................................................................................ BA
O

2,634
2,327
299
675
6,683
6,929

3,123
2,516
493
694
7,997
8,304

3,034
2,766
900
612
8,323
8,392

3,097
2,895
994
787
8,443
8,592

3,166
2,961
675
796
8,610
8,808

3,239
3,156
675
736
8,801
9,058

3,315
3,229
1,123
839
9,002
9,268

Subtotal, acquisition of major equipment ........................................... BA
O

9,616
9,931

11,613
11,514

12,257
11,770

12,534
12,274

12,451
12,565

12,715
12,950

13,440
13,336

Purchase or sale of land and structures .................................................... BA
O

747
704

589
614

219
377

532
627

220
290

555
612

571
621

Subtotal, national defense investment ....................................................
NONDEFENSE
Major public physical investment:
Construction and rehabilitation:
Highways ..................................................................................................

Subtotal, construction and rehabilitation .............................................

136

ANALYTICAL PERSPECTIVES

Table 7–2. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: DEFENSE AND NONDEFENSE PROGRAMS—Continued
(in millions of dollars)

2001
Actual

Description
Other physical assets (grants) .....................................................................

Estimate
2002

2003

2004

2005

2006

2007

BA
O

1,332
939

1,321
1,087

1,257
1,114

1,330
1,182

1,388
1,260

1,422
1,346

1,470
1,396

Subtotal, major public physical investment ............................................ BA
O

95,069
81,168

97,472
88,282

88,200
86,913

84,962
85,978

91,799
84,692

92,427
85,473

95,208
86,456

11,898
10,913
1,445
1,336
1,679
1,420
22,114
18,852
2,122
1,749
4,061
3,683

12,046
11,453
1,685
1,635
1,706
1,208
25,104
22,488
2,183
1,897
4,243
4,253

13,155
12,418
1,533
1,596
1,456
1,603
28,625
25,207
2,087
1,888
4,029
4,297

13,966
13,276
1,674
1,637
1,401
1,531
29,139
27,976
2,129
1,860
4,103
4,458

14,275
13,924
1,724
1,682
1,474
1,511
29,789
29,342
2,174
1,887
4,175
4,512

14,608
14,231
1,790
1,747
1,507
1,539
30,480
29,994
2,225
1,933
4,264
4,639

14,954
14,589
1,827
1,777
1,541
1,570
31,155
30,716
2,278
1,960
4,355
4,748

BA
O

43,319
37,953

46,967
42,934

50,885
47,009

52,412
50,738

53,611
52,858

54,874
54,083

56,110
55,360

Conduct of education and training:
Education, training, employment and social services:
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

24,981
22,993
18,040
17,202
2,857
2,572
5,555
5,129
9,339
8,265

32,986
26,644
20,621
18,295
2,587
2,995
5,338
5,953
9,946
9,347

34,387
31,786
19,187
19,080
2,552
2,680
4,800
5,804
10,057
9,866

35,104
34,065
18,743
18,264
2,605
2,598
4,907
5,425
10,271
10,133

35,888
35,019
19,254
18,563
2,643
2,608
5,018
4,973
10,501
10,395

36,725
35,778
19,775
19,042
2,698
2,664
5,136
4,989
10,746
10,618

37,588
36,607
20,301
19,560
2,753
2,713
5,257
5,107
10,999
10,859

Conduct of research and development:
General science, space and technology .....................................................

BA
O
Energy .......................................................................................................... BA
O
Transportation ............................................................................................... BA
O
Health ........................................................................................................... BA
O
Natural resources and environment ............................................................ BA
O
All other research and development ........................................................... BA
O
Subtotal, conduct of research and development ....................................

Subtotal, education, training, and social services ..............................

BA
O

60,772
56,161

71,478
63,234

70,983
69,216

71,630
70,485

73,304
71,558

75,080
73,091

76,898
74,846

Veterans education, training, and rehabilitation ..........................................

BA
O
BA
O
BA
O

2,635
2,221
1,408
1,161
2,180
1,773

2,804
2,893
1,563
1,399
2,312
2,340

2,939
3,255
1,257
1,340
2,246
2,250

3,427
3,443
1,280
1,309
2,221
2,311

3,592
3,627
1,309
1,358
2,285
2,372

3,764
3,759
1,339
1,394
2,348
2,412

3,923
3,898
1,370
1,418
2,412
2,470

BA
O

66,995
61,316

78,157
69,866

77,425
76,061

78,558
77,548

80,490
78,915

82,531
80,656

84,603
82,632

Subtotal, nondefense investment ............................................................ BA
O

205,383
180,437

222,596
201,082

216,510
209,983

215,932
214,264

225,900
216,465

229,832
220,212

235,921
224,448

327,041
292,556

353,640
324,552

358,317
342,573

367,916
351,347

387,318
367,067

401,796
380,009

422,074
392,330

Health ...........................................................................................................
Other education and training .......................................................................
Subtotal, conduct of education and training ...........................................

Total, Federal investment ..............................................................................

BA
O

7.

137

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS
(in millions of dollars)

Estimate

2001
Actual

2002

2003

2004

2005

2006

2007

34,564
27,206
7,210
6,760
..................
7
2,597
2,020

35,136
28,841
6,576
6,222
..................
2
3,176
2,801

30,716
27,804
6,915
6,330
..................
..................
3,404
3,273

26,336
24,879
7,059
6,425
..................
..................
3,462
3,407

31,775
24,054
7,218
6,457
..................
..................
3,524
3,502

32,365
24,271
7,386
6,408
..................
..................
3,591
3,613

32,966
24,662
7,559
7,106
..................
..................
3,659
3,689

BA
O

44,371
35,993

44,888
37,866

41,035
37,407

36,857
34,711

42,517
34,013

43,342
34,292

44,184
35,457

BA
O
BA
O
BA
O
BA
O
BA
O
BA
O
BA
O

2,851
2,720
82
67
5,112
4,939
1,921
1,320
7,285
7,198
1,213
11
913
165

2,898
2,651
36
66
7,000
5,235
1,304
1,530
7,238
7,618
48
506
204
185

2,581
2,891
41
75
4,732
5,878
1,227
1,499
7,057
7,673
45
329
203
201

2,635
2,922
42
59
4,831
6,526
1,254
1,405
7,205
8,060
46
342
207
213

2,694
2,919
43
58
4,938
5,472
1,280
1,316
7,365
8,091
47
343
210
216

1,853
2,875
44
48
5,053
4,950
1,311
1,262
7,538
8,580
48
347
215
220

1,897
2,742
45
49
5,171
5,014
1,342
1,303
7,713
7,637
49
355
219
226

Subtotal, other construction and rehabilitation ...............................

BA
O

19,377
16,420

18,728
17,791

15,886
18,546

16,220
19,527

16,577
18,415

16,062
18,282

16,436
17,326

Subtotal, construction and rehabilitation .............................................

BA
O

63,748
52,413

63,616
55,657

56,921
55,953

53,077
54,238

59,094
52,428

59,404
52,574

60,620
52,783

Other physical assets .................................................................................. BA
O

1,417
990

1,417
1,158

1,318
1,209

1,393
1,237

1,451
1,316

1,487
1,407

1,537
1,453

BA
O

65,165
53,403

65,033
56,815

58,239
57,162

54,470
55,475

60,545
53,744

60,891
53,981

62,157
54,236

BA
O
BA
O

269
238
264
144

268
259
249
191

258
265
250
304

263
298
237
288

270
281
266
283

275
297
269
292

282
304
231
293

BA
O

533
382

517
450

508
569

500
586

536
564

544
589

513
597

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

22,511
21,326
449
360
775
670
4,090
3,791
8,967
7,960
461
458
268

31,180
24,671
449
523
635
896
3,827
4,516
9,569
8,739
465
505
451

33,172
29,750
382
445
633
734
3,261
4,317
9,701
9,526
448
463
328

33,864
32,260
390
445
655
680
3,376
4,030
9,908
9,784
457
470
338

34,621
33,261
399
449
659
660
3,452
3,646
10,129
10,038
468
487
359

35,429
33,991
408
455
675
675
3,533
3,664
10,365
10,254
478
504
379

36,261
34,778
418
467
690
690
3,616
3,755
10,609
10,485
490
515
399

Description
GRANTS TO STATE AND LOCAL GOVERNMENTS
Major public physical investments:
Construction and rehabilitation:
Transportation:
Highways ............................................................................................. BA
O
Mass transportation ............................................................................. BA
O
Rail transportation ............................................................................... BA
O
Air transportation ................................................................................. BA
O
Subtotal, transportation ...................................................................
Other construction and rehabilitation:
Pollution control and abatement .............................................................
Other natural resources and environment ..............................................
Community development block grants ....................................................
Other community and regional development ..........................................
Housing assistance ..................................................................................
Department of Education .........................................................................
Other construction ...................................................................................

Subtotal, major public physical investments ...........................................
Conduct of research and development:
Agriculture .....................................................................................................
Other .............................................................................................................
Subtotal, conduct of research and development ....................................

138

ANALYTICAL PERSPECTIVES

Table 7–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS—Continued
(in millions of dollars)

2001
Actual

Description
O

Estimate
2002

2003

2004

2005

2006

2007

244

394

301

285

298

313

326

Subtotal, conduct of education and training ...........................................

BA
O

37,521
34,809

46,576
40,244

47,925
45,536

48,988
47,954

50,087
48,839

51,267
49,856

52,483
51,016

Subtotal, grants for investment ...............................................................

BA
O

103,219
88,594

112,126
97,509

106,672
103,267

103,958
104,015

111,168
103,147

112,702
104,426

115,153
105,849

BA
O
Atomic energy defense activities and other ....................................... BA
O

7,672
6,875
491
577

9,330
7,525
752
693

7,753
8,292
663
655

8,827
8,136
676
679

10,050
7,900
690
692

14,528
8,852
704
706

17,497
11,217
719
722

BA
O

8,163
7,452

10,082
8,218

8,416
8,947

9,503
8,815

10,740
8,592

15,232
9,558

18,216
11,939

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

758
392
3,026
3,034
5,002
4,476
2,192
1,970
1,426
1,436
327
1,039
332
383
34
22
1,298
1,237
732
504
1,184
959
3,315
1,729

1,343
932
2,394
2,675
4,379
4,569
1,902
1,893
1,990
1,981
851
612
317
359
35
26
1,766
1,593
680
411
1,545
1,325
3,131
3,034

1,440
1,058
2,065
2,254
3,861
4,209
1,795
1,910
1,271
1,272
1,331
1,039
370
412
35
33
1,891
1,591
244
625
1,543
1,298
1,700
1,998

1,470
1,242
2,033
2,149
3,928
3,983
1,833
1,999
1,357
1,359
983
1,080
376
383
36
33
1,927
1,702
249
454
1,575
1,336
1,722
1,937

1,504
1,352
2,078
2,150
4,295
4,130
1,874
1,961
1,760
1,762
1,114
1,070
386
376
37
33
1,968
1,776
255
339
1,610
1,388
1,765
1,812

1,539
1,401
2,126
2,193
4,157
4,266
1,919
1,960
1,385
1,386
1,048
1,103
393
390
37
34
2,013
1,821
261
329
1,648
1,420
1,805
1,688

1,574
1,434
2,177
2,245
4,248
4,266
1,963
2,001
1,316
1,318
1,532
1,267
402
401
38
35
2,061
1,865
267
336
1,687
1,449
1,842
1,703

DIRECT FEDERAL PROGRAMS
Major public physical investment:
Construction and rehabilitation:
National defense:
Military construction and family housing ............................................

Subtotal, national defense ..............................................................
Nondefense:
International affairs ..............................................................................

Subtotal, nondefense ......................................................................

BA
O

19,626
17,181

20,333
19,410

17,546
17,699

17,489
17,657

18,646
18,149

18,331
17,991

19,107
18,320

Subtotal, construction and rehabilitation .............................................

BA
O

27,789
24,633

30,415
27,628

25,962
26,646

26,992
26,472

29,386
26,741

33,563
27,549

37,323
30,259

BA
O
BA
O

63,679
56,131
110
106

62,994
60,802
109
105

70,305
63,600
109
108

76,166
66,708
111
116

80,634
76,460
113
120

88,360
83,208
116
123

100,415
89,016
118
125

BA
O

63,789
56,237

63,103
60,907

70,414
63,708

76,277
66,824

80,747
76,580

88,476
83,331

100,533
89,141

BA
O
BA
O
BA

504
388
990
1,042
118

476
495
702
671
116

471
489
632
620
116

475
456
655
638
116

485
468
670
659
105

496
484
686
676
102

507
495
702
692
103

Acquisition of major equipment:
National defense:
Department of Defense .......................................................................
Atomic energy defense activities ........................................................
Subtotal, national defense ..............................................................
Nondefense:
General science and basic research ..................................................
Space flight, research, and supporting activities ...............................
Energy ..................................................................................................

7.

139

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS—Continued
(in millions of dollars)

Estimate

2001
Actual

2002

2003

2004

2005

2006

2007

118
299
675
2,634
2,327
271
441
520
553
..................
80
653
960
502
409
1,340
1,197
410
552
1,290
1,138

116
493
694
3,123
2,516
482
472
621
854
..................
64
606
782
1,020
917
1,859
2,021
562
562
1,457
1,279

116
900
612
3,034
2,766
547
460
521
571
..................
47
610
915
1,255
1,098
1,904
1,827
656
656
1,550
1,498

116
994
787
3,097
2,895
558
487
532
562
..................
49
623
937
1,280
1,183
1,933
1,859
668
668
1,540
1,582

105
675
796
3,166
2,961
571
526
544
544
..................
52
637
955
1,306
1,211
1,976
1,943
679
679
1,574
1,610

102
675
736
3,239
3,156
584
556
556
556
..................
56
653
979
1,333
1,233
2,024
2,000
691
691
1,611
1,664

103
1,123
839
3,315
3,229
598
578
570
570
..................
59
668
1,002
1,362
1,259
2,072
2,046
704
704
1,649
1,703

BA
O

9,531
9,880

11,517
11,443

12,196
11,675

12,471
12,219

12,388
12,509

12,650
12,889

13,373
13,279

Subtotal, acquisition of major equipment ........................................... BA
O

73,320
66,117

74,620
72,350

82,610
75,383

88,748
79,043

93,135
89,089

101,126
96,220

113,906
102,420

BA
O
International affairs .................................................................................. BA
O
Privatization of Elk Hills ........................................................................... BA
O
Other ........................................................................................................ BA
O

–14
–21
27
88
..................
..................
720
616

–4
–9
1
1
..................
..................
588
613

–14
–12
3
1
..................
..................
216
376

–31
–31
3
1
..................
..................
529
626

–31
–31
3
1
–323
–323
540
612

–31
–31
3
1
..................
..................
552
611

–31
–31
3
1
..................
..................
568
620

Subtotal, purchase or sale of land and structures ............................ BA
O

733
683

585
605

205
365

501
596

189
259

524
581

540
590

Subtotal, major public physical investment ............................................ BA
O

101,842
91,433

105,620
100,583

108,777
102,394

116,241
106,111

122,710
116,089

135,213
124,350

151,769
133,269

BA
O
BA
O

46,702
45,454
3,011
2,990

53,721
50,213
4,134
4,133

59,354
56,311
3,629
3,628

62,533
57,744
3,694
3,723

66,191
61,657
3,763
3,796

64,442
63,065
3,837
3,866

63,516
62,884
3,911
3,941

BA
O

49,713
48,444

57,855
54,346

62,983
59,939

66,227
61,467

69,954
65,453

68,279
66,931

67,427
66,825

Description
O
Postal Service ..................................................................................... BA
O
Air transportation ................................................................................. BA
O
Water transportation (Coast Guard) ................................................... BA
O
Other transportation (railroads) ........................................................... BA
O
Social security ..................................................................................... BA
O
Hospital and medical care for veterans ............................................. BA
O
Department of Justice ......................................................................... BA
O
Department of the Treasury ................................................................ BA
O
GSA general supply fund .................................................................... BA
O
Other .................................................................................................... BA
O
Subtotal, nondefense ......................................................................

Purchase or sale of land and structures:
National defense ......................................................................................

Conduct of research and development:
National defense
Defense military .......................................................................................
Atomic energy and other .........................................................................
Subtotal, national defense ..................................................................

Nondefense:
International affairs .................................................................................. BA
O
General science, space and technology:
NASA ................................................................................................... BA
O
National Science Foundation .............................................................. BA
O
Department of Energy ......................................................................... BA
O

252
215

268
214

182
186

186
246

190
269

195
284

199
296

6,432
6,060
3,075
2,566
2,391
2,287

6,339
6,085
3,285
2,943
2,422
2,425

7,228
6,847
3,441
3,085
2,486
2,486

7,953
7,546
3,475
3,200
2,538
2,530

8,130
7,966
3,550
3,375
2,595
2,583

8,320
8,193
3,633
3,396
2,655
2,642

8,517
8,406
3,719
3,479
2,718
2,704

Subtotal, general science, space and technology ......................... BA
O

12,150
11,128

12,314
11,667

13,337
12,604

14,152
13,522

14,465
14,193

14,803
14,515

15,153
14,885

140

ANALYTICAL PERSPECTIVES

Table 7–3. FEDERAL INVESTMENT BUDGET AUTHORITY AND OUTLAYS: GRANT AND DIRECT FEDERAL PROGRAMS—Continued
(in millions of dollars)

2001
Actual

Description
Energy ..........................................................................................................

Estimate
2002

2003

2004

2005

2006

2007

BA
O

1,445
1,336

1,685
1,635

1,533
1,596

1,674
1,637

1,724
1,682

1,790
1,747

1,827
1,777

Transportation:
Department of Transportation ................................................................. BA
O
NASA ........................................................................................................ BA
O

558
410
973
906

648
593
918
498

488
589
817
791

478
550
793
780

507
507
811
808

518
518
830
822

531
529
849
838

BA
O

2,976
2,652

3,251
2,726

2,838
2,976

2,945
2,967

3,042
2,997

3,138
3,087

3,207
3,144

BA
O
BA
O

20,993
17,905
1,043
929

23,860
21,257
1,159
1,195

27,504
24,051
1,033
1,110

27,992
26,809
1,053
1,102

28,613
28,246
1,078
1,022

29,279
28,870
1,101
1,042

29,964
29,570
1,130
1,068

BA
O

22,036
18,834

25,019
22,452

28,537
25,161

29,045
27,911

29,691
29,268

30,380
29,912

31,094
30,638

BA
O
Natural resources and environment ............................................................ BA
O
National Institute of Standards and Technology ......................................... BA
O
Hospital and medical care for veterans ...................................................... BA
O
All other research and development ........................................................... BA
O

1,389
1,281
2,122
1,749
374
408
746
857
993
662

1,437
1,384
2,183
1,897
421
416
794
943
1,031
999

1,445
1,393
2,087
1,888
366
443
844
994
923
981

1,472
1,470
2,129
1,860
374
400
862
1,018
933
1,004

1,489
1,501
2,174
1,887
382
380
880
1,042
952
1,026

1,524
1,562
2,225
1,933
392
381
901
1,067
967
1,037

1,558
1,600
2,278
1,960
401
385
923
1,093
983
1,058

Subtotal, nondefense .......................................................................... BA
O

42,786
37,571

46,450
42,484

50,377
46,440

51,912
50,152

53,075
52,294

54,330
53,494

55,597
54,763

BA
O

92,499
86,015

104,305
96,830

113,360
106,379

118,139
111,619

123,029
117,747

122,609
120,425

123,024
121,588

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 research .......................................................... BA
O
National defense .......................................................................................... BA
O
International affairs ....................................................................................... BA
O
Other ............................................................................................................. BA
O

2,470
1,667
17,591
16,842
2,082
1,902
1,465
1,338
1,390
1,143
2,635
2,221
802
575
7
7
369
311
670
508

1,806
1,973
20,172
17,772
1,952
2,099
1,511
1,437
1,549
1,385
2,804
2,893
928
905
8
8
248
285
611
873

1,215
2,036
18,805
18,635
1,919
1,946
1,539
1,487
1,243
1,326
2,939
3,255
952
927
8
8
258
291
630
622

1,240
1,805
18,353
17,819
1,950
1,918
1,531
1,395
1,266
1,295
3,427
3,443
892
943
8
8
263
284
648
692

1,267
1,758
18,855
18,114
1,984
1,948
1,566
1,327
1,294
1,344
3,592
3,627
912
928
8
8
269
290
664
740

1,296
1,787
19,367
18,587
2,023
1,989
1,603
1,325
1,324
1,380
3,764
3,759
933
926
8
8
276
274
678
773

1,327
1,829
19,883
19,093
2,063
2,023
1,641
1,352
1,355
1,404
3,923
3,898
955
943
8
8
282
280
691
794

Subtotal, transportation ...................................................................
Health:
National Institutes of Health ................................................................
All other health ....................................................................................
Subtotal, health ...............................................................................
Agriculture .....................................................................................................

Subtotal, conduct of research and development ....................................

Subtotal, conduct of education and training ...........................................

BA
O

29,481
26,514

31,589
29,630

29,508
30,533

29,578
29,602

30,411
30,084

31,272
30,808

32,128
31,624

Subtotal, direct Federal investment ........................................................

BA
O

223,822
203,962

241,514
227,043

251,645
239,306

263,958
247,332

276,150
263,920

289,094
275,583

306,921
286,481

Total, Federal investment ..............................................................................

BA
O

327,041
292,556

353,640
324,552

358,317
342,573

367,916
351,347

387,318
367,067

401,796
380,009

422,074
392,330

7.

141

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Part II: 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 7–4 shows the value of the net federally financed physical capital stock since 1960, in constant fiscal year 1996 dollars. The total stock grew at
a 2.2 percent average annual rate from 1960 to 2001,
with periods of faster growth during the late 1960s
and the 1980s. The stock amounted to $1,965 billion
in 2001 and is estimated to increase to $2,066 billion
by 2003. In 2001, the national defense capital stock
accounted for $635 billion, or 32 percent of the total,
and nondefense stocks for $1,331 billion, or 68 percent
of the total.

142

ANALYTICAL PERSPECTIVES

Table 7–4.

NET STOCK OF FEDERALLY FINANCED PHYSICAL CAPITAL
(In billions of 1996 dollars)
Nondefense

Fiscal Year

Five year intervals:
1960 ....................................................
1965 ....................................................
1970 ....................................................
1975 ....................................................
1980 ....................................................
1985 ....................................................
1990 ....................................................
Annual data:
1995 ....................................................
1996 ....................................................
1997 ....................................................
1998 ....................................................
1999 ....................................................
2000 ....................................................
2001 ....................................................
2002 est. .............................................
2003 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

806
892
1,044
1,091
1,216
1,422
1,696

572
554
589
521
484
569
721

234
338
455
570
732
853
975

98
128
155
176
206
234
269

61
78
94
109
130
143
154

36
51
61
67
76
90
114

136
209
301
394
526
619
706

82
146
213
261
317
368
429

25
30
44
71
112
135
147

20
21
25
39
73
92
105

9
12
19
23
25
24
26

1,832
1,845
1,858
1,869
1,890
1,922
1,965
2,017
2,066

712
691
672
657
644
635
635
639
645

1,119
1,153
1,186
1,212
1,246
1,286
1,331
1,378
1,421

311
319
327
330
338
351
364
379
392

164
165
165
165
166
167
170
173
175

146
154
162
165
173
183
194
206
217

809
834
859
883
908
936
967
999
1,029

496
511
526
540
556
574
595
617
637

156
159
162
165
168
170
173
176
179

115
116
118
119
120
121
123
124
126

43
48
53
59
65
70
76
82
87

Real stocks of defense and nondefense capital show
very different trends. Nondefense stocks have grown
consistently since 1970, increasing from $455 billion
in 1970 to $1,331 billion in 2001. With the investments
proposed in the budget, nondefense stocks are estimated to grow to $1,421 billion in 2003. During the
1970s, the nondefense capital stock grew at an average
annual rate of 4.9 percent. In the 1980s, however, the
growth rate slowed to 2.9 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, a large defense buildup began to increase the stock of defense
capital. By 1986, the defense stock had exceeded its
earlier Vietnam-era peak. In recent years, depreciation
on the increased stocks, together with a slower pace
of defense physical capital investment allowed by the
collapse of the Soviet Union and the closure or realignment of unneeded military bases, reduced the stock
from its previous levels. The increased defense investment in this budget would reverse this decline.
Another trend in the Federal physical capital stocks
is the shift from direct Federal assets to grant-financed
assets. In 1960, 42 percent of federally financed nondefense capital was owned by the Federal Government,
and 58 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 slower growth in direct Federal
investment for water resources, for example, shifted the
composition of the stock substantially. In 2001, 27 percent of the nondefense stock was owned by the Federal

Government and 73 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 7–5 shows nondefense physical capital outlays
both gross and net of depreciation since 1960. Total
nondefense net investment has been consistently positive over the period covered by the table, indicating
that new investment has exceeded depreciation on the
existing stock. For some categories in the table, such
as water and power programs, however, 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 7–4.
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 7–6, the R&D capital
stock financed by Federal outlays is estimated to be
$933 billion in 2001 in constant 1996 dollars. Roughly

7.

143

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–5.

COMPOSITION OF GROSS AND NET FEDERAL AND FEDERALLY FINANCED NONDEFENSE PUBLIC PHYSICAL
INVESTMENT
(In billions of 1996 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 ........................
2000 ........................
2001 ........................
2002 est. .................
2003 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

22.7
32.5
32.1
32.9
46.9
45.4
46.3

4.7
6.9
9.4
11.6
14.6
17.8
22.3

18.1
25.6
22.6
21.3
32.4
27.7
24.0

7.0
10.1
6.9
9.0
11.0
13.7
16.2

2.2
3.0
3.8
4.3
4.9
6.4
9.2

4.7
7.1
3.1
4.8
6.0
7.4
7.0

2.5
3.3
2.3
3.6
3.9
2.6
2.4

2.3
3.8
0.8
1.2
2.2
4.8
4.5

15.7
22.3
25.1
23.8
36.0
31.7
30.1

2.4
3.8
5.6
7.4
9.6
11.4
13.1

13.3
18.5
19.5
16.5
26.4
20.3
17.1

12.6
15.5
11.9
7.0
12.3
13.0
11.9

0.1
2.1
5.1
4.3
7.5
4.1
1.7

0.1
0.4
0.9
4.5
6.8
3.2
2.1

0.5
0.5
1.6
0.7
–0.2
–0.1
1.4

59.9
61.1
60.9
55.5
63.5
71.1
76.3
81.3
78.2

26.3
27.3
28.2
29.0
29.8
30.9
32.2
33.8
35.3

33.5
33.8
32.7
26.6
33.7
40.2
44.1
47.5
42.9

19.5
20.7
20.0
15.5
21.3
25.7
27.7
30.7
28.5

11.4
11.8
12.3
12.6
12.9
13.5
14.3
15.2
16.1

8.2
8.9
7.7
2.9
8.4
12.2
13.3
15.4
12.3

1.8
0.9
–0.1
–*
0.7
1.6
2.7
3.1
1.9

6.3
8.0
7.8
2.9
7.8
10.6
10.7
12.3
10.4

40.3
40.3
40.9
40.0
42.2
45.4
48.6
50.6
49.7

15.0
15.4
15.9
16.4
16.8
17.4
17.9
18.5
19.1

25.4
24.9
25.0
23.7
25.3
28.1
30.7
32.1
30.6

15.2
14.9
15.2
14.1
16.1
18.1
21.0
21.5
19.9

2.8
3.0
2.9
2.7
2.7
2.7
2.8
3.1
3.4

2.0
1.6
1.5
1.1
1.2
1.6
1.5
1.5
1.6

5.4
5.5
5.3
5.8
5.3
5.7
5.4
6.0
5.6

* $50 million or less.

half is the stock of basic research knowledge; the remainder is the stock of applied research and development.
The nondefense stock accounted for about three-fifths
of the total federally financed R&D stock in 2001. Although investment in defense R&D has exceeded that
of nondefense R&D in every year since 1981, 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.
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.
Increased defense R&D spending from 1980 through
1990 led to a more rapid growth of the R&D stock.
Subsequently, real defense R&D outlays tapered off,
depreciation grew, and, as a result, the real net defense
R&D stock stabilized at around $400 billion.
The growth of the nondefense R&D stock slowed from
the 1970s to the 1980s, from an annual rate of 3.8
percent in the 1970s to a rate of 2.1 percent in the
1980s. 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 7–7, the federally financed education stock is estimated at $1,057 billion in 2001 in
constant 1996 dollars, rising to $1,157 billion in 2003.
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.1 Nearly threequarters 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 5.3 percent
from 1970 to 2001, 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 7–4 through 7–7.
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 in
the period in which the spending takes place. In reality,
1 For estimates of the total education stock, see table 3–4 in Chapter 3, ‘‘Stewardship:
Toward a Federal Balance Sheet.’’

144

ANALYTICAL PERSPECTIVES

Table 7–6.

NET STOCK OF FEDERALLY FINANCED RESEARCH AND DEVELOPMENT 1
(In billions of 1996 dollars)
National Defense

Fiscal Year
Total

Five year intervals:
1970 ..................................................................
1975 ..................................................................
1980 ..................................................................
1985 ..................................................................
1990 ..................................................................
Annual data:
1995 ..................................................................
1996 ..................................................................
1997 ..................................................................
1998 ..................................................................
1999 ..................................................................
2000 ..................................................................
2001 ..................................................................
2002 est. ..........................................................
2003 est. ..........................................................
1 Excludes

Basic
Research

Nondefense

Applied
Research
and
Development

Basic
Research

Total

Total Federal
Applied
Research
and
Development

Total

Basic
Research

Applied
Research
and
Development

247
262
265
304
381

15
19
24
29
34

233
242
242
276
347

204
249
295
321
362

63
92
125
165
217

140
157
170
156
146

451
511
560
626
744

78
112
148
194
251

373
399
412
432
493

399
401
403
403
402
398
400
405
413

40
42
43
44
45
46
47
48
49

359
360
360
360
358
353
353
357
364

436
448
463
478
495
512
533
558
585

278
290
303
317
331
347
366
386
408

158
158
160
162
164
164
167
172
177

835
850
866
882
897
910
933
963
999

318
332
346
360
376
393
413
434
458

517
518
520
522
521
517
520
529
541

stock of physical capital for research and development, which is included in Table 7–4.

Table 7–7.

NET STOCK OF FEDERALLY FINANCED EDUCATION
CAPITAL
(In billions of 1996 dollars)
Total
Education
Stock

Fiscal Year

Five year intervals:
1960 ...............................................................................
1965 ...............................................................................
1970 ...............................................................................
1975 ...............................................................................
1980 ...............................................................................
1985 ...............................................................................
1990 ...............................................................................
Annual data:
1995 ...............................................................................
1996 ...............................................................................
1997 ...............................................................................
1998 ...............................................................................
1999 ...............................................................................
2000 ...............................................................................
2001 ...............................................................................
2002 est. ........................................................................
2003 est. ........................................................................

the value of the asset created could be more or less
than the investment spending. As an extreme example,
in cases where a project is canceled before completion,
the spending on the project does 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 a capital asset.
For example, payments for constructing an aircraft carrier might be made over a period of years, with the
capital 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

Elementary
and Secondary
Education

Higher
Education

67
93
213
307
434
535
703

48
67
167
247
338
399
519

19
26
46
60
96
137
184

792
822
856
909
968
1,013
1,057
1,094
1,157

575
597
621
661
707
742
769
793
839

218
226
235
248
261
271
288
301
318

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 historical 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

7.

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

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 1996 prices were made through the application of price measures from the National Income and
Product Accounts (NIPAs), but these should be considered only approximations of the costs of these assets
in 1996 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.
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 two recent
comprehensive revisions of the NIPAs in January 1996
and October 1999, 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, as part of the most recent revisions, a
new NIPA table explicitly links investment and capital
stocks by reporting the net stock of Government physical capital and decomposing the annual change in the
stock into investment, depreciation, extraordinary
changes such as disasters, and revaluation.2
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
2 BEA most recently presented its capital stocks in ‘‘Fixed Assets and Consumer Durable
Goods for 1925–2000,’’ Survey of Current Business, September 2001, pp. 27–38.

145

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 1996 dollars were based on chained NIPA
price indexes 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.3 The geometric rates were 1.9 percent for water and power
projects; 2.4 percent for other direct nondefense construction and rehabilitation; 20.3 percent for nondefense equipment; 14.0 percent for defense equipment;
2.1 percent for defense structures; 2.0 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 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 1996 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.4 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 ex3 BEA presented its depreciation methods and rates in ‘‘Improved Estimates of Fixed
Reproducible Tangible Wealth, 1929–95,’’ Survey of Current Business, May 1997, pp. 69–76.
Changes in depreciation methods introduced with BEA’s October 1999 comprehensive revisions were detailed in ‘‘Fixed Assets and Consumer Durable Goods,’’ Survey of Current
Business, April 2000, pp. 17–30.
4 See U.S. Department of Labor, Bureau of Labor Statistics, The Impact of Research
and Development on Productivity Growth, Bulletin 2331, September 1989.

146

ANALYTICAL PERSPECTIVES

tension to basic research would result in smaller stocks
than the method used here.5
Education Capital Stocks
Method of estimation.—The estimates of the federally
financed education capital stock in Table 7–7 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 per-

cent in any year was estimated by averaging the prior
years’ share of Federal education outlays in total education costs. For more information, refer to the technical note in Chapter 3, ‘‘Stewardship: Toward a Federal Balance Sheet.’’
The stock of capital estimated in Table 7–7 is based
only on spending for education. Stocks created by other
human capital investment outlays included in Table
7–1, 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.

Part III: 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. This
section is intended to show the implications of budgeting for capital separately or changing the basis for
measuring capital investment in the budget. An Administration proposal being developed for capital acquisition funds is discussed in chapter 1 of this volume,
‘‘Budget and Performance Integration.’’ It would neither
budget for capital separately nor change the basis for
measuring capital investment in the budget.
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
discussion that follows, the first is called ‘‘Federal capital’’ and the second is called ‘‘national capital.’’ Table
7–8 compares total Federal investment as defined in
Part I of this chapter with investment in Federal capital and 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. The proposals differ widely in coverage, depending on the rationale for the suggestion. Some would
include all the investment shown in Table 7–1, or more,
whereas others would be narrower in various ways.
5 See ‘‘A Satellite Account for Research and Development,’’ Survey of Current Business,
November 1994, pp. 37–71.

These proposals also differ in other respects, such as
whether the basis for measuring capital investment in
the budget is altered, whether investment would be
financed by borrowing, 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 process for capital assets, which is a different subject, is discussed
in a separate publication, the Capital Programming
Guide.6
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 to meet a goal derives from these decisions;
the optimal amount of total investment to meet all
of the Government’s goals derives from these decisions
and from the policy decisions about how much to allocate for each goal. 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.
6 Office

of Management and Budget, Capital Programming Guide (July 1997).

7.

147

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–8.

ALTERNATIVE DEFINITIONS OF INVESTMENT OUTLAYS, 2003
(In millions of dollars)
Investment Outlays
All types
of capital 1

Federal
capital

National
capital

37,407
2,966
7,377
7,673
530

................
................
................
................
................

37,407
2,966
1,238
................
425

8,947
2,254
6,119
1,272
412
1,591
1,039
1,298
3,714

8,947
2,239
4,933
1,272
359
1,591
1,039
1,298
3,360

................
2,254
5,583
1,272
412
1,591
1,039
................
1,300

Total construction and rehabilitation .....................................................
Acquisition of major equipment (direct):
National defense .............................................................................................
Postal Service .................................................................................................
Air transportation ............................................................................................
Other ...............................................................................................................

82,599

25,038

55,487

63,708
612
2,766
8,297

63,708
612
2,766
7,466

................
612
2,766
4,198

Total major equipment ...............................................................................
Purchase or sale of land and structures ...........................................................
Other physical assets (grants) ...........................................................................

75,383
365
1,209

74,552
365
................

7,576
................
95

Total physical investment ...............................................................................
Research and development:
Defense ...........................................................................................................
Nondefense .....................................................................................................

159,556

99,955

63,158

59,939
47,009

................
................

1,277
46,668

Total research and development ...............................................................
Education and training ........................................................................................

106,948
76,069

................
................

47,945
75,436

Total investment outlays .....................................................................................

342,573

99,955

186,539

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
7–1. Some capital is not classified as either Federal or national capital, and a relatively small part is included in
both categories.

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 2003 is estimated to be $100.0 billion, or 29 percent of the total
Federal investment outlays shown in Table 7–1. Of the
investment in Federal capital, 73 percent is for defense
and 27 percent for nondefense purposes.
A Capital Budget for Capital Assets
Discussion of a capital budget has often centered on
Federal capital—buildings, other construction, equipment, and software 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 equip-

ment; 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.
Some capital budget proposals would partition the
unified budget into a capital budget, an operating budget, and a total budget. Table 7–9 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 con-

148

ANALYTICAL PERSPECTIVES

solidates the operating and capital budgets by adding
them together and netting out depreciation as an
intragovernmental transaction. The operating budget
has a smaller deficit than the unified budget by a modest amount, by $17 billion, because capital expenditures
are larger than depreciation by $18 billion. (The difference between these two amounts is due to rounding.)
This reflects both the small Federal investment in new
capital assets relative to the budget as a whole ($100
billion) and the largely offsetting effect of depreciation
on the existing stock ($82 billion). The figures in Table
7–9 and the subsequent tables of this section are rough
estimates, intended only to be illustrative and to provide a basis for broad generalizations.
Table 7–9.

CAPITAL, OPERATING, AND UNIFIED BUDGETS:
FEDERAL CAPITAL, 2003 1 2
(In billions of dollars)

Operating Budget
Receipts ..................................................................................................
Expenses:
Depreciation .......................................................................................
Other ..................................................................................................

82
2,028

Subtotal, expenses ........................................................................

2,111

Surplus or deficit (–) ..........................................................................
Capital Budget
Income: depreciation ..............................................................................
Capital expenditures ..............................................................................

–63

Surplus or deficit (–) ..........................................................................
Unified Budget
Receipts ..................................................................................................
Outlays ...................................................................................................

–18
2,048
2,128

Surplus or deficit (–) ..........................................................................

–80

2,048

82
100

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 categor
2 The details of this table do not add to the totals in every case due to rounding.

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 7–9.
For 2003, this exclusion would make little difference
to the operating budget surplus. If defense capital was
excluded, the operating budget would have a deficit
that was $12 billion less than the unified budget surplus instead of $17 billion less as shown above for the
complete coverage of Federal capital. Capital expenditures for defense in 2003 are estimated to be $6 billion
more than depreciation, whereas capital expenditures
for nondefense purposes (plus military family housing)
are estimated to be $12 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 acquisi-

tions in terms of the operating budget instead. When
an agency 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.7 If the asset was constructed or built to order,
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, in which
case the budget would record no expense at all in the
budget year or several years thereafter.
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 is not permanent, it is 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 noted above, it could even be zero
if the asset was made to order. 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
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.
7 The amount of depreciation that typically would be recorded as an expense in the
budget year for an already existing asset is overstated by this illustration. Most assets
are purchased after the beginning of the year, in which case less than a full year’s depreciation would normally be recorded.

7.

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

The present budget does this for investment. It
records investment on a cash basis, and it requires
Congress to vote budget authority before an agency can
obligate the Government to make an outlay. By these
means, 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).8
This comparison is also consistent with common business practice, in which most capital budgeting decisions
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.9 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.10
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’’
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
8 A 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.
9 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).
10 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.

149

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.11 This supports the business’s goal
of deciding upon and controlling the use of its resources
to earn income.
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 costs of capital assets over their estimated
useful lives. With similar objectives in mind, the Federal Accounting Standards Advisory Board has 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.12
Businesses finance investment from net income, cash
on hand, 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, 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;
11 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.
12 Statement of Federal Financial Accounting Standards No. 6, Accounting for Property,
Plant, and Equipment, pp. 5–14 and 34–35. (The Federal Accounting Standards Advisory
Board was established by the Office of Management and Budget, Department of Treasury,
and General Accounting Office to develop accounting standards and concepts for the Federal
government. The American Institute of Certified Public Accountants has designated it as
the body to establish generally accepted accounting principles (GAAP) for Federal government entities.) 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.

150

ANALYTICAL PERSPECTIVES

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. The only
constraint is policy decisions about the budget.
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 State taxes, which may be substantial, State
operating budgets do not record any amount. No State
operating budget is charged for depreciation.13
States did not traditionally record depreciation expense in the financial accounting statements for governmental funds. They recorded depreciation expense only
in their proprietary (commercial-type) funds and in
those trust funds where net income, expense, or capital
maintenance was measured.14 Under new financial accounting standards, however, depreciation on most capital assets will be recognized as an expense in government-wide financial statements. This requirement is
now being phased-in and is effective for larger governments for fiscal years beginning after June 2001.15
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. Rating agencies place significant
weight on the amount of debt outstanding compared
to the economic output generated by the State. 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, has traditionally been divided into
separate titles of which some are for current expenditures and others for capital expenditures. A study of

European countries several years ago found only four
at that time which had a real difference between a
current budget and a capital budget (Greece, Ireland,
Luxembourg, and Portugal).16
In addition, three developed countries have recently
adopted accrual budgets that include the use of depreciation in place of capital expenditures. These countries,
however, require appropriations for the full cost or current cash disbursements as an additional control under
some or all circumstances. New Zealand, the first country to shift to an accrual budget, requires the equivalent of appropriations for the full cost up front before
a department can make net additions to its capital
assets or before the government can acquire certain
capital assets such as state highways. It also requires
Cabinet approval for purchases above a threshold
amount. Australia, which adopted an accrual budget
as of its 1999–2000 budget, requires an appropriation
for departments that do not have adequate reserves
to purchase assets. The United Kingdom budgeted on
an accrual basis starting with its 2001–02 fiscal year.
However, Parliamentary approval is needed for both
the ‘‘resource budget,’’ which includes depreciation, and
the departmental cash requirement, which includes the
cash payments made for capital assets.
Canada publishes its budget on a modified accrual
basis and intends to shift to full accruals, including
the depreciation of capital assets. However, it distinguishes between its budget and its ‘‘estimates.’’ The
budget sets forth the overall fiscal framework, while
the ‘‘estimates’’ comprise the detailed departmental appropriations. The estimates are on a modified cash
basis, different from the budget, that does not make
use of depreciation. This would be an additional control
in the context of a full accrual budget.
A country with an accrual budget may calculate its
measure of fiscal position on other bases as well. The
Australian budget has several measures of fiscal position. The primary fiscal measure, the fiscal balance,
is close to a cash basis and includes the purchase of
property, plant, and equipment rather than depreciation.17
On the other hand, some countries—including Sweden, Denmark, Finland, and the Netherlands—formerly
had separate capital budgets but abandoned them a
number of years ago.18 The Netherlands and Sweden,
though, are either planning to adopt accruals for their

13 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 (November 1999).
14Governmental Accounting Standards Board (GASB), Codification of Governmental Accounting and Financial Reporting Standards as of June 30, 2000, sections 1100.107 and
1400.114–1400.118.
15 Governmental Accounting Standards Board, Statement No. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments (June
1999), paragraphs 18–29 and 44–45. For discussion of the basis for conclusions of these
new standards, see paragraphs 330–43.

16 M. Peter van der Hoek, ‘‘Fund Accounting and Capital Budgeting: European Experience,’’
Public Budgeting and Financial Management, vol. 8 (Spring 1996), pp. 39–40.
17 The practices and plans of New Zealand, Australia, United Kingdom, and Canada
are discussed in GAO, Accrual Budgeting: Experiences of Other Nations and Implications
for the United States, GAO/AIMD-00–57 (February 2000).
18 Denmark had accrual budgets generally, not just for capital assets, but abandoned
that practice a number of years ago. The budgets in Sweden, Great Britain, Germany,
and France as of the middle 1980s 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 Swedish Budget System:
A Summary of the Report of the Budget Commission Published by the Ministry of Finance
(Stockholm, 1974), chapter 10.

7.

151

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

budget generally or are actively considering whether
to do so.
Many developing countries operate a dual budget
system comprising a regular or recurrent budget and
a capital or development budget. The World Bank staff
has concluded that:
‘‘The dual budget may well be the single most
important culprit in the failure to link planning,
policy and budgeting, and poor budgetary outcomes. The dual budget is misconceived because
it is based on a false premise that capital expenditure by government is more productive than current expenditure. Separating development and recurrent budgets usually leads to the development
budget having a lower hurdle for entry. The result
is that everyone seeks to redefine their expenditure as capital so it can be included in the development budget. Budget realities are left to the
recurrent budget to deal with, and there is no
pretension that expenditure proposals relate to
policy priorities.’’19
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.’’20
After further study of the role of depreciation in
budgeting for national capital, GAO reiterated that conclusion in another study in 1995.21 ‘‘The greatest disadvantage . . . was that depreciation would result in
a loss of budgetary control under an obligation-based
budgeting system.’’22 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 expressly 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
19 The World Bank, Public Expenditure Management Handbook (Washington, D.C.: The
World Bank, 1998), Box 3.11, page 53.
20 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.
21 GAO, Budget Issues: The Role of Depreciation in Budgeting for Certain Federal Investments, GAO/AIMD-95–34 (February 1995), pp. 1 and 19–20.
22 Ibid., p. 17. Also see pp. 1–2 and 16–19.

small fraction of an asset’s cost would be included in
the year when a decision was made to acquire it.’’23
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.
• The effect of Federal taxation, borrowing, and
other policies on private investment.
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.24 GAO defined this investment as
‘‘federal spending, either direct or through grants, that
is directly intended to enhance the private sector’s longterm productivity.’’25 To increase investment—both public and private—GAO recommended establishing targets
for the level of Federal investment.26 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 formation of national capital. GAO reiterated its recommendation in another report in 1995.27
Table 7–10.

UNIFIED BUDGET WITH NATIONAL INVESTMENT
COMPONENT, 2003
(In billions of dollars)

Receipts ....................................................................................................
Outlays:
National investment .............................................................................
Other ....................................................................................................

2,048
187
1,942

Subtotal, outlays ..............................................................................

2,128

Surplus or deficit (–) ............................................................................

–80

Table 7–10 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 $187 billion in 2003. It includes
infrastructure outlays financed by Federal grants to
State and local governments, such as highways and
23 GAO, Budget Issues: Budgeting for Federal Capital, GAO/AIMD-97–5 (November 1996),
p. 28. Also see p. 4.
24 Incorporating an Investment Component in the Federal Budget, pp. 1–2, 9–10, and
15.
25 Ibid., pp. 1 and 5.
26 Ibid., pp. 2 and 13–16.
27 The Role of Depreciation in Budgeting for Certain Federal Investments, pp. 2 and 19–20.

152
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 11 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 7–11 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.28
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
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.29

28 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.’’
29These 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 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).

ANALYTICAL PERSPECTIVES

Table 7–11.

CAPITAL, OPERATING, AND UNIFIED BUDGETS:
NATIONAL CAPITAL, 20031 2
(In billions of dollars)

Operating Budget
Receipts ..................................................................................................
Expenses:
Depreciation 3 .....................................................................................
Other ..................................................................................................

81
1,942

Subtotal, expenses ........................................................................

2,023

Surplus or deficit (–) ..........................................................................
Capital Budget
Income:
Depreciation 3 .....................................................................................
Earmarked tax receipts 4 ...................................................................

–6

Subtotal, income ............................................................................
Capital expenditures ..............................................................................

113
187

Surplus or deficit (–) ..........................................................................
Unified Budget
Receipts ..................................................................................................
Outlays ...................................................................................................

–74
2,048
2,128

Surplus or deficit (–) .....................................................................

–80

2,016

81
32

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 3. All depreciation estimtes are subject to the limitations explained in Part II of this
chapter. Depreciation is measured in terms of current cost, not historical cost.
2 The details of this table do not add to the totals in every case due to rounding.
3 Excludes depreciation on capital financed by earmarked tax receipts allocated to the capital budget.
4 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.

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 II 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
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 fulfilled by the Federal sector of the national income and product accounts (NIPA)
for Government purchases of structures, equipment,
and software. The NIPA Federal sector measures the
impact of Federal current receipts, current expenditures, and the current surplus or 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

7.

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

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.30
The NIPA Federal sector distinguishes between government purchases of goods and services for consumption and investment.31 It is a current account or an
operating account for the Federal Government and accordingly shows current receipts and current expenditures. It excludes expenditures for structures, equipment, and software owned by the Federal Government;
it includes depreciation on the federally owned stock
of structures, equipment, and software as a proxy for
the services of capital assets consumed in production
and thus as part of the Federal Government’s current
expenditures. It applies this treatment to a comprehensive definition of federally owned structures, equipment,
and software, both defense and nondefense, similar to
the definition of Federal capital in this chapter.32
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 2001 Federal
Government current account surplus was reduced $1.3
billion by including depreciation rather than gross investment, because depreciation of federally owned
structures, equipment, and software was more than
gross investment. The 2003 Federal current account
surplus is estimated to be increased $2.5 billion.33 A
capital budget is not needed to capture this effect.
Borrowing to Finance a Capital Budget
A further issue traditionally 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 gen30 See chapter 17 of this volume, ‘‘National Income and Product Accounts,’’ for the NIPA
current account of the Federal Government based on the budget actuals and estimates
for 2001-03, and for a discussion of the NIPA Federal sector and its relationship to the
budget.
31 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 vary. For example,
the SNA does not include the purchase of military equipment as investment.
32 The treatment of investment (except for the recent recognition of software) in the
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, equipment, and software remain a part of gross domestic product (GDP) as a separate component. The NIPA State and local government account
is defined in the same way and includes depreciation on structures, equipment, and software
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 summary
tables of the government account: depreciation on general government capital assets is
included as part of government ‘‘consumption expenditures’’; and depreciation on the capital
assets of government enterprises is subtracted in calculating the ‘‘current surplus of government enterprises.’’
33 See actuals and estimates for 2001–03 in Table 17–2 of chapter 17 of this volume,
‘‘National Income and Product Accounts.’’

153

erations that will benefit from the investment. The additional debt is ‘‘justified’’ by the additional assets.
As this argument has traditionally been framed, it
might appear as though it did not always apply. The
Government has had a large surplus for several years,
which was mostly used to repay Federal debt held by
the public; and although a deficit is estimated in 2002
and 2003, largely due to the recession and the response
to the terrorist attacks, the budget estimates a return
to surplus in 2005. When the Government has a surplus, additional expenditure is generally financed by
repaying less debt rather than borrowing more. However, the argument about borrowing for investment is
fundamentally about the proper target for Federal debt
and whether that target should be higher if the Government has net investment. If the Government has deficits financed by selling debt, should it borrow more
than otherwise because of its net investment? Or if
the Government has surpluses used to repay debt,
should it repay less than otherwise because of its net
investment? This section follows the traditional way
of discussing the issue by referring to ‘‘borrowing to
finance net investment.’’ However, for the present analysis, ‘‘borrowing more’’ is equivalent to ‘‘repaying less
debt.’’
This argument about financing capital expenditures
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 7–9 and 7–11 suggest that this rationale would currently justify some
change in borrowing (or debt repayment) under the two
capital budgets roughly illustrated in this chapter, but
for Federal capital the change would not be much. For
Federal capital, Table 7–9 indicates that current cost
depreciation is less than gross investment for Federal
capital—the capital budget deficit is $18 billion. The
rationale of borrowing to finance net investment would

154

ANALYTICAL PERSPECTIVES

justify the Federal Government borrowing this amount
($18 billion) and no more to finance its investment in
Federal capital. For national capital, Table 7–11 indicates that current cost depreciation (plus the excise
taxes earmarked to finance capital expenditures for
highways and airports and airways 34) is less than gross
investment—the capital budget deficit is $74 billion.
The rationale of borrowing to finance net investment
would justify the Federal Government borrowing this
amount ($74 billion) and no more to finance its investment in national capital.35
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 encourage
private investment as well as its own national investment. A high level of net national saving is needed
to meet the demographic and other 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
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.36
The present budget estimates a deficit this year
largely due to the recession and the response to the
terrorist attacks, but it also estimates a return to surplus in 2005. This will prevent the Government from
crowding out private investment once the economy is
stronger. A capital budget is not a justification to relax
the budget discipline that will contribute to this goal.

Part IV: 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 2002 enacted
appropriations and adjusted for inflation in later years.

34 The capital budget deficit would be about $17 billion larger if current cost depreciation
were used instead of earmarked excise taxes for investment in highways and airports
and airways.
35 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

The current services concept is discussed in Chapter
15, ‘‘Current Services Estimates.’’
Federal public physical capital spending was $144.8
billion in 2001 and is projected to increase to $190.0
billion by 2011 on a current services basis. The largest
components are for national defense and for roadways
and bridges, which together accounted for more than
three-fifths of Federal public physical capital spending
in 2001.
Table 7–12 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 $38.9 billion in
2001, and current services outlays are estimated to increase to $53.2 billion by 2011. Outlays for nondefense
housing and buildings were $13.5 billion in 2001 and
are estimated to be $18.4 billion in 2011. Physical capital outlays for other nondefense categories were $28.7
billion in 2001 and are projected to be $38.5 billion
by 2011. For national defense, this spending was $63.7
billion in 2001 and is estimated on a current services
basis to be $79.9 billion in 2011.
Table 7–13 shows current services projections on a
constant dollar basis, using fiscal year 1996 as the base
year.

disbursements of the direct loan and guaranteed loan financing accounts. See chapter 13
of this volume, ‘‘Federal Borrowing and Debt,’’ and the explanation of Table 13–2.
36 GAO considered deficit financing of investment but did not recommend it. See Incorporating an Investment Component in the Federal Budget, pp. 12–13.

7.

155

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Table 7–12.

CURRENT SERVICES OUTLAY PROJECTIONS FOR FEDERAL PHYSICAL CAPITAL SPENDING
(In billions of dollars)
2001
Actual

Nondefense:
Transportation-related categories:
Roadways and bridges ...................................................................................
Airports and airway facilities .........................................................................
Mass transportation systems .........................................................................
Railroads ........................................................................................................

Estimate
2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

27.2
4.4
6.8
0.6

28.9
5.3
6.2
0.9

30.9
6.0
6.4
0.7

32.1
6.4
6.4
0.7

33.0
6.7
6.4
0.7

33.8
7.0
6.2
0.7

34.6
7.1
6.9
0.7

35.3
7.2
7.1
0.7

36.0
7.4
7.2
0.7

36.7
7.5
7.3
0.8

37.4
7.7
7.5
0.8

Subtotal, transportation ..................................................................................
Housing and buildings categories:.
Federally assisted housing ............................................................................
Hospitals .........................................................................................................
Public buildings 1 ............................................................................................

38.9

41.3

44.0

45.7

46.7

47.8

49.3

50.3

51.3

52.3

53.2

7.9
1.8
3.8

9.1
1.9
5.6

8.2
2.0
5.8

8.7
2.1
6.4

8.8
2.2
6.1

9.3
2.3
6.2

8.4
2.3
6.3

8.4
2.4
6.4

8.6
2.4
6.5

8.8
2.5
6.7

9.0
2.6
6.8

Subtotal, housing and buildings ....................................................................
Other nondefense categories:
Wastewater treatment and related facilities .................................................
Water resources projects ..............................................................................
Space and communications facilities ............................................................
Energy programs ...........................................................................................
Community development programs ..............................................................
Other nondefense ..........................................................................................

13.5

16.5

15.9

17.1

17.1

17.8

17.0

17.2

17.6

18.0

18.4

3.3
4.8
6.1
1.6
5.6
7.3

3.1
4.9
4.9
2.1
6.1
9.3

3.3
4.7
5.3
1.9
7.0
9.2

3.3
4.7
5.6
1.9
8.4
9.8

3.4
4.9
5.7
1.9
8.3
9.8

3.4
5.1
5.7
2.0
8.2
10.4

3.6
5.1
6.1
2.0
8.3
10.6

3.7
5.2
6.2
2.0
8.4
10.9

3.7
5.3
6.5
2.0
8.5
11.1

3.8
5.5
6.8
2.1
8.7
11.4

3.8
5.6
6.5
2.1
8.9
11.7

Subtotal, other nondefense ...........................................................................

28.7

30.5

31.5

33.8

34.0

34.7

35.6

36.4

37.3

38.2

38.5

Subtotal, nondefense .....................................................................................
National defense ......................................................................................................

81.2
63.7

88.3
69.1

91.4
69.9

96.6
71.6

97.8
73.4

100.3
74.8

101.9
76.0

104.0
75.7

106.1
77.0

108.5
78.4

110.1
79.9

Total ..........................................................................................................................

144.8

157.4

161.3

168.2

171.1

175.1

177.9

179.6

183.2

186.9

190.0

1 Excludes

outlays for public buildings that are included in other categories in this table.

156

ANALYTICAL PERSPECTIVES

Table 7–13.

CURRENT SERVICES OUTLAY PROJECTIONS FOR FEDERAL PHYSICAL CAPITAL SPENDING
(In billions of constant 1996 dollars)
2001
Actual

Nondefense:
Transportation-related categories:
Roadways and bridges ...................................................................................................
Airports and airway facilities ............................................................................................
Mass transportation systems .........................................................................................
Railroads ..........................................................................................................................

Estimate
2002

2003

2004

2005

2006

24.8
4.2
6.2
0.6

25.8
5.0
5.5
0.9

26.9
5.4
5.6
0.7

27.3
5.7
5.5
0.7

27.3
5.8
5.3
0.6

27.3
6.0
5.0
0.6

Subtotal, transportation ................................................................................................
Housing and buildings categories:
Federally assisted housing ..............................................................................................
Hospitals ...........................................................................................................................
Public buildings 1 ..............................................................................................................

35.7

37.1

38.6

39.1

39.0

39.0

7.3
1.8
3.7

8.2
1.8
5.4

7.1
1.9
5.5

7.4
2.0
5.9

7.3
2.0
5.7

7.6
2.0
5.6

Subtotal, housing and buildings ..................................................................................
Other nondefense categories:
Wastewater treatment and related facilities ..................................................................
Water resources projects ...............................................................................................
Space and communications facilities .............................................................................
Energy programs ............................................................................................................
Community development programs ...............................................................................
Other nondefense ............................................................................................................

12.8

15.4

14.5

15.3

15.0

15.2

3.0
4.8
6.1
1.5
5.1
7.2

2.8
4.8
4.8
2.0
5.5
8.9

2.8
4.5
5.0
1.9
6.1
8.7

2.8
4.5
5.3
1.8
7.2
9.1

2.8
4.5
5.2
1.8
6.9
8.9

2.8
4.6
5.2
1.8
6.6
9.2

Subtotal, other nondefense .........................................................................................

27.8

28.8

29.1

30.6

30.2

30.2

Subtotal, nondefense .......................................................................................................
National defense .......................................................................................................................

76.3
65.2

81.3
69.2

82.2
68.8

85.0
69.2

84.2
69.7

84.4
69.8

Total ..........................................................................................................................................

141.5

150.5

151.0

154.3

153.9

154.1

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.

7.

157

FEDERAL INVESTMENT SPENDING AND CAPITAL BUDGETING

Significant Factors Affecting Infrastructure Needs Assessments
Highways
1. Projected annual average growth in travel to the year 2017 ...................................................................................
2. Annual cost to maintain 1997 physical conditions on highways ..............................................................................
3. Annual cost to maintain 1997 physical conditions on bridges ..................................................................................

2.16 percent
$50.8 billion (1997 dollars)
$5.8 billion (1997 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 .....................

$7.7 billion (1997 dollars)
$3.1 billion (1997 dollars)

Wastewater Treatment
1. Total remaining needs of sewage treatment facilities ...............................................................................................
2. Total Federal expenditures under the Clean Water Act of 1972 through 2001 ......................................................
3. The population served by centralized treatment facilities: percentage that benefits from at least secondary
sewage treatment systems ...........................................................................................................................................
4. States and territories served by State Revolving Funds ...........................................................................................

$128 billion (1996 dollars)
$79 billion
99 percent
51

Housing
1. Total unsubsidized very low income renter households with worst case needs (4.9 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.

0.5 million
4.6 million

Indian Health Service (IHS) Health Care Facilities
1.
2.
3.
4.
5.

IHS hospital occupancy rates (2000) ...........................................................................................................................
Average length of stay, IHS hospitals (days) (2001) .................................................................................................
Hospital admissions (2001) ..........................................................................................................................................
Outpatient visits (2001) ...............................................................................................................................................
Eligible population (2001) ............................................................................................................................................

39.9 percent
4.1
63,560
7,772,926
1,540,129

1.
2.
3.
4.
5.

Department of Veterans Affairs (VA) Hospitals (2002)
Medical Centers ............................................................................................................................................................
Outpatient clinics .........................................................................................................................................................
Domiciliaries .................................................................................................................................................................
Vet centers ....................................................................................................................................................................
Nursing homes ..............................................................................................................................................................

172
852
43
206
137

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.
Surface Transportation
Department of Transportation. 1999 Status of the Nation’s Surface Transportation System: Conditions and

158
Performance: Report to Congress. 2000. This report discusses roads, bridges, and mass transit.
Airports and Airways Facilities
Federal Aviation Administration. National Airspace
Systems Capital Investment Plan: 2003–2007, February
2002.
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.
FY 2001 Indian Health Service and Tribal Hospital
Inpatient Statistics.
Office of Audit, Office of Inspector General, U.S. Department of Health and Human Services. Review of
Health Facilities Construction Program. Indian Health

ANALYTICAL PERSPECTIVES

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.
Wastewater Treatment
Environmental Protection Agency, Office of Water.
1996 Needs Survey Report to Congress. (EPA
832–R–87–003).
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.

8. RESEARCH AND DEVELOPMENT
I.

INTRODUCTION

Technological innovation and scientific discovery generated much of the Nation’s economic growth over the
last 50 years, creating millions of jobs, and improving
the quality of life. For example, about two-thirds of
the 80 percent gain in economic productivity since 1995
can be attributed to information technology. This innovation and discovery was possible because of both public and private investment in research and development
(R&D).
The United States’ investment in R&D is unparalleled. Our country’s investment in R&D plays a major
role in the state of the world’s science and technology.
Not only does the U.S. continue to lead the world in
total R&D spending, but, as the most recent data indicate in the accompanying figure, U.S. R&D expenditures—combining private and public—exceed those of
the rest of the G–7 countries combined.
The Nation’s investments in innovation and discovery
are also vital to strengthening our capabilities to combat terrorism and defend our country. The President’s

2003 Budget focuses on winning the war against terrorism and securing the homeland, while moderating
the growth in overall spending. These priorities have
affected the way R&D is being funded and directed,
as well as the way the results of R&D are being used.
Within the federal government’s research portfolio,
agencies have been directing many of their programs
to assist in the defense effort. For example, one focus
of R&D at the Department of Defense (DOD) is to improve detection of biological and chemical threats; the
National Institutes of Health (NIH) is financing and
conducting research to discover new disease treatments;
and the Department of Transportation (DOT) is performing R&D to improve aviation security technology.
Investments today in R&D will translate into the new
capabilities for tomorrow for detecting threats to our
security, defending ourselves against them, and responding to emergencies should they arise.

Chart 8-1. U.S. R&D Expenditures Exceed
Those of the Rest of the G-7 Nations Combined
In billions of dollars (1999)
300

250

Canada
Italy
United Kingdom

200

150

United States

France
Germany

100

50

Japan

0
Source: National Science Foundation

159

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ANALYTICAL PERSPECTIVES

If adopted, this budget will provide the highest level
of funding for R&D in history, but the focus should
not be on how much we are spending, but rather on
what we are getting for our investment. Our current
priorities also call for redoubling our efforts to meet
the President’s charge that we improve the management, performance, and results of the federal government. A dedicated effort to improve the overall quality
of the total investment in R&D by strengthening effective programs and fixing lower performers through reforms or reallocations will increase the productivity of
the federal R&D portfolio and transcend the all-toocommon attention given to year-to-year marginal increases or decreases. Additionally, while it can be difficult to assess the outcomes of some research programs—many of which may not have a measurable effect for decades—it is important to establish meaningful
goals for them and to measure annual progress toward
them and performance in appropriate ways. Towards
that end, the Administration is developing investment
criteria for R&D programs across the government. Finally, the government must coordinate interrelated and
complementary R&D efforts among agencies, combining
programs where appropriate to improve effectiveness
and eliminating redundant programs, to leverage these
resources to the greatest effect.
The federal government has multiple roles in achieving these goals. The government should be strong in
II.

its support of basic research, as it is the source of
tomorrow’s discoveries and new capabilities, and it will
fuel further gains in economic productivity, quality of
life, and national security. The government should also
support those areas of applied research and development critical to the missions of the federal agencies,
particularly in priority areas that private sources are
not motivated to support. If the private sector cannot
profit from the development of a particular technology,
federal funding may be appropriate if the technology
in question addresses a National priority or otherwise
provides societal benefits. Finally, the federal government should help stimulate private investment and provide the proper incentives for private sources to continue to fuel the discovery and innovation of tomorrow.
The Administration plans to do this through the permanent extension of the Research and Experimentation
tax credit.
To these ends, this chapter discusses how the Administration will improve the performance of R&D programs through new investment principles and other
means that encourage and reinforce quality research.
The chapter also highlights the priority areas proposed
for R&D agencies and the coordinated efforts among
them. The chapter concludes with details of R&D funding data across the federal government.

IMPROVING PERFORMANCE OF R&D PROGRAMS

R&D is critically important for keeping our Nation
economically competitive. It will help solve the challenges we face in health, defense, energy, and the environment. As a result, and consistent with the Government Performance and Results Act, every federal R&D
dollar must be invested as effectively as possible.
R&D Investment Principles
The Administration is improving the effectiveness of
the federal government’s investments in R&D by sub-

jecting investment decisions to transparent investment
criteria. R&D requires special consideration in the context of performance assessment, as many R&D outcomes—especially those of basic research—may not be
obvious for years or decades. Nevertheless, the government must improve its basis for deciding among R&D
investments, including applying specific criteria that
projects must meet and clear milestones for measuring
performance.

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8. RESEARCH AND DEVELOPMENT FUNDING

The Department of Energy (DOE) R&D Performance Pilot: As announced in the President’s
Management Agenda, the Administration developed investment criteria using DOE’s applied energy
R&D programs as a pilot. These are the Fossil Energy, Nuclear Science and Technology, and Energy
Efficiency and Renewable Energy programs. The Administration is using the R&D criteria to recommend funding levels for the Department’s applied R&D programs that support the President’s National Energy Policy report.
In the first year of the pilot project, application of the criteria indicated that data on the expected
performance of many R&D projects are not readily available. For instance, using one energy-based
metric, some of 19 Fossil Energy R&D programs failed to report any performance data at all, and
those that did tended to report goals rather than the current cost performance of technologies under
development. The Department, in conjunction with the Office of Management and Budget, is working
to improve these performance metrics and data. DOE will improve the grading method to distinguish
among programs more effectively. In this first year, about 80 percent of the criteria graded by DOE
achieved a maximum score.
Despite these initial problems, the criteria provided enough guidance to determine some opportunities for redirecting funds. In the fossil energy program, research to control greenhouse gases was increased, since there is little incentive for private investment in this area. Conversely, areas such as oil
drilling technology, where the industry has the financing and incentive to do its own research, are
funded at lower levels. Within DOE’s renewable energy portfolio, wind power research will shift focus
from technologies for high wind-speed areas to cost-effective technologies for low wind-speed areas,
which are further from commercial viability and show great promise for greatly expanding the land
area that can be used to capture this renewable energy resource. DOE will continue to work to integrate the R&D criteria more meaningfully into their budget formulation process in the coming year.

Based on lessons learned from the DOE pilot project
and other inputs from experts and stakeholders, the
Administration will develop R&D investment criteria
to assist with budget allocation decisions at major R&D
agencies starting in the 2004 budget process. While
the specific criteria to be used in 2004 are still under
development, several fundamental principles motivate
and will guide them, including:
• Federal R&D priorities should be consistent with
priorities identified by the President.
• Federal R&D programs should focus on activities
that require a federal presence to attain national
goals. To avoid public funds displacing private investment, federally funded R&D should focus primarily on areas where the private sector cannot
capture the benefits of the R&D.
• Programs and proposals should have thorough
plans for the research, with clear goals and
planned end points or off-ramps, when appropriate.
• To maximize the quality of the research process
and the efficiency of the public investment, research programs should use a competitive, meritbased process where appropriate. Exceptions must
be well justified.
• Agencies and programs judged to be outstanding
in conducting, awarding, and managing R&D
should be identified and supported.
• Less successful programs should follow successful
models to achieve improvements, or they should
be reduced or moved to agencies where they can
be managed more effectively.
• Resources for new R&D priorities will be increased
by reducing or eliminating the funding for pro-

grams that have completed their mission or that
are redundant or obsolete.
The Administration recognizes that researcher time
is best spent on research and that added administrative
burden for researchers is counterproductive. During the
development and implementation of the investment criteria, the Administration will take the necessary steps
to minimize their administrative burden and maximize
their utility.
The Administration has been studying management
strategies for R&D that some agencies use to promote
particularly effective programs. OMB and the Office of
Science and Technology Policy (OSTP) are developing
a common analytical framework to assess the strengths
and weaknesses of R&D programs across agencies, in
order to identify and apply good R&D management
practices across the government. For example, some
agencies have more deliberate prioritization process,
while other agencies have more experience estimating
the returns of R&D and assessing the impact after the
fact. The process of developing this framework will be
iterative, involving the research agencies and the
science and technology community.
Due to the distinct goals and methods of basic research versus applied research and development, separate criteria are being developed. The Office of Science
and Technology Policy (OSTP), OMB, and the federal
agencies will work with the science and technology community to define helpful criteria and implement them
effectively in preparation of the 2004 budget.
Using some of the principles identified above, the
President’s Budget begins to improve the performance
of research programs across the government.

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ANALYTICAL PERSPECTIVES

As an example of improving a program, the Administration is reforming the Department of Education’s Office of Educational Research and Improvement (OERI)
by implementing a more rigorous grant solicitation and
peer review process. The Department is also developing
a reauthorization proposal for OERI that should allow
it to improve the quality, objectivity, coordination, and
focus of the Department’s research activities.
The budget transfers some R&D programs between
agencies. For example, the transfer of the U.S. Geological Survey’s Toxic Substances Hydrology program and
the National Oceanic and Atmospheric Administration’s
Sea Grant program to NSF’s more competitive, peerreview award process will improve the scientific rigor
of the research. The peer review process allows the
assessment of merit by other experts in the field, while
competition ensures that the grants ultimately awarded

have demonstrated their merit, over other competitive
proposals.
Research Earmarks
The Administration supports awarding research
funds based on merit review through a competitive
process. Such a system ensures that the best research
is supported. Research earmarks—in general the assignment of money during the appropriation process
for use only by a specific organization or project—are
counter to the competitive process of selection based
on merit. The use of earmarks improperly signals to
potential investigators that there is an alternative to
creating quality research proposals for merit-based consideration, including the use of political influence or
by appealing to parochial interests.

Chart 8-2. Funding for Academic Earmarks
In millions of dollars
2,000

1,668
1,500

1,044
1,000

797

440

500

528

296

0
1996

1997

1998

1999

2000

2001

Source: The Chronicle of Higher Education

Moreover, the practice of earmarking funds directly
to colleges and universities for specific research projects
has expanded dramatically in recent years. Despite
broad-based support for merit review, earmarks for specific projects at colleges and universities have yet again
broken prior records. According to The Chronicle of
Higher Education, academic earmarks have steadily increased from a level of $296 million in 1996 to an
estimated $1.67 billion in 2001. In 2001 alone, earmarked funds to colleges and universities increased

nearly 60 percent (see figure). These funds represent
an increasing share of the total federal funding to colleges and universities, which increasingly displaces
competitive research, awarded by merit. For example,
in 1996, academic earmarks accounted for 2.5 percent
of all federal funding to colleges and universities. By
2001, the earmarked share of federal academic funding
had increased to a high of 9.4 percent. While comparable figures for 2002 are not yet available, the assessment of research allocation in Table 8–5 at the

163

8. RESEARCH AND DEVELOPMENT FUNDING

end of this chapter suggests that this trend has continued to grow for non-defense agencies in 2002.
Some argue that earmarks help spread the research
money to the states that would receive less research
funding through other means. However, The Chronicle
of Higher Education reports that this is not the main
role they play. In 1999, for example, only a small share
of academic earmark funding went to the states with
the smallest shares of federal research funds. In fact,
the 25 states with the largest shares of federal research
dollars also received 74 percent of the earmark funding
to colleges and universities. Meanwhile, earmarks help
some rich institutions become richer. In 1999, 13 of
the 25 institutions receiving the most earmarks were
also members of the top 100 for total research funds.
Table 8–7 provides a list of the 30 colleges and universities that received the most earmarked funding in
2001, according to The Chronicle of Higher Education
(results for 2002 are not available at this time).
There is a tendency to confuse a high budget number
appropriated for an agency with a good outcome for
the agency, but this is often not the case. Often, earmarks drive these increases. Worse yet, the flood of
earmarks within that level displaces important competitive programs that have to be deferred or terminated.
For example, in 2002 appropriations, earmarked funding for constructing a low priority propulsion lab at
the National Aeronautics and Space Administration
(NASA) was paid for by cutting the very research that
the lab is to support.
Earmarks for research facilities can come at the cost
of operations or research at those facilities. For example, earmarks in DOE’s Office of Science increased 60
percent from 2001 to 2002. As a result, DOE has only
the resources to operate its scientific user facilities at
approximately 75 percent of the optimally available

hours. Had these funds been allocated to facility operations as needed, a broader segment of the research
community could have benefited, and the return on the
federal investment in these facilities would have been
higher.
Some proponents of earmarking assert that earmarks
provide a means of funding unique projects that would
not be recognized by the conventional peer-review process. On the contrary, a number of agencies have procedures and programs to reward out-of-the-box thinking
in the research they award. For example, DOD’s Defense Advanced Research Projects Agency seeks out
high risk, high payoff scientific proposals, and NSF program managers set aside a share of funding for higherrisk projects in which they see high potential.
Many earmarks have little to do with an agency’s
mission. For example, Congress earmarked DOD’s 2002
budget to fund research on a wide range of diseases,
including breast cancer, ovarian cancer, prostate cancer,
diabetes, and osteoporosis. Funding at DOD for such
research totals over $600 million in that year alone.
While research on these diseases is very important,
it is not unique to the U.S. military and can be carried
out and coordinated better within civil medical research
agencies, without disruption to the military mission.
The Administration is working with the scientific
community to discourage the practice of research earmarks. Academic organizations, such as the Association
of American Universities, and colleges and universities,
including Massachusetts Institute of Technology and
Washington University in St. Louis, have stated that
they share the Administration’s preference for merit
review and recognize the problems with academic earmarks. The Administration will continue to work with
such organizations and universities and the Congress
to achieve our common objectives.

III. PRIORITIES FOR FEDERAL RESEARCH AND DEVELOPMENT
The 2003 budget requests record levels for federal
R&D ($111.8 billion, an 8 percent increase, as shown
in Table 8–2). The Administration recognizes that investments in research—especially in basic research—
will lead to the discoveries and technologies of tomorrow. The 2003 budget includes an emphasis on basic
research, increasing associated funding across the agencies by $2.0 billion (or 9 percent).
In a 1995 report from the National Academy of
Sciences, the scientific community proposed a ‘‘Federal
Science and Technology’’ (FS&T) budget. Such a compilation highlights activities central to the creation of
new knowledge and technologies more consistently and
accurately than the traditional R&D data collection reported in Table 8–2. As shown in Table 8–3, the 2003
budget requests $57.0 billion for FS&T (a 9 percent
increase). The resulting FS&T budget is less than half
of the total federal spending on R&D, though FS&T
also includes some funding that is not R&D. Discussions of agency efforts in this section include the FS&T
values from Table 8–3.

Some in the science community call for greater ‘‘balance’’ across research agencies and disciplines, at times
suggesting that all agencies should receive increases
similar to those that NIH and other agencies have received. However, ‘‘balance’’ by that definition makes
prioritization impossible. Increases in our top-priority
research areas should logically be greater than increases for other areas. Instead, the 2003 budget provides funding for top priority areas, while ensuring a
good mix of basic, applied, and development in many
fields of science and technology across the federal agencies. The Administration believes the focus should not
be on how much we are spending, but rather on what
we are getting for our investment and how well it is
being managed.
Over the past year, OSTP and OMB have worked
with the federal agencies and the science community
to identify top priorities for federal R&D. Some are
in areas critical to the Nation, such as information
technologies. Some are in emerging fields, such as
nanotechnology, that will provide new breakthroughs

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ANALYTICAL PERSPECTIVES

across many fields. Others, such as anti-terrorism R&D,
address newly recognized needs. The discussion below
identifies four multi-agency priority areas, followed by
highlights of agency-specific R&D priorities.
Multi-Agency R&D Priorities
The 2003 budget targets investments in important
research that benefits from improved coordination
across multiple agencies. Two of these multi-agency initiatives—nanotechnology and information technology
R&D—have separate coordination offices under the auspices of NSF to ensure coordinated strategic planning
and implementation. Both initiatives will be producing
integrated plans to describe detailed research proposals
for 2003. The Administration is in the process of forming new organizations and strengthening interagency
coordination for two priority areas—anti-terrorism and
climate change R&D. The Administration will continue
to consider other areas of critical need that could benefit in the future from improved focus and coordination
among agencies.
Anti-terrorism R&D: Scientific and technological
advances will be used to prevent and respond to possible future terrorist activities at home and abroad.
Potential antiterrorism R&D applications span a wide
range, including safeguarding the mail, developing new
vaccines and air safety systems, and creating advanced
materials and enhanced building designs. Most aspects
of our national life are being assessed for vulnerabilities
to terrorists. Often, the scientific and technological community will be asked to devise solutions in cost-effective
ways that do not impinge on our way of life. Over
the next six months, OMB, OSTP, and the Office of
Homeland Security will be working through the National Science and Technology Council (NSTC) to develop a coordinated, interagency R&D plan for
antiterrorism.
This
budget
identifies
many
antiterrorism R&D priorities (such as rapid detection
and verification of biological threats). The NSTC plan
will chart a comprehensive and integrated course for
these efforts as well as provide cross-agency budgetary
information.
Networking and Information Technology R&D:
The budget provides $1.9 billion (a 3 percent increase)
for the multi-agency Networking and Information Technology Research and Development Program (NITRD).
By coordinating key advanced information technology
research efforts, the NITRD agencies leverage resources
to make broader advances in computing and networking
than a single agency could attain. For example, the
NITRD agencies develop and deploy computing platforms and software that perform over a trillion computing operations per second, to support advanced federal research in the biomedical sciences, earth and
space sciences, physics, materials science and engineering, and related scientific fields. Accomplishments include: development of end-to-end optical fiber networking, providing vast improvements in bandwidth
and network security for research and commercial ap-

plications; new technologies enabling cluster, or ‘‘grid,’’
computing, providing for the first time access to highperformance computation for scientific researchers nationwide; technologies for network security protection
such as intrusion detection and risk and vulnerability
analyses; and technologies for archiving, managing, and
using large-scale information repositories, or ‘‘digital libraries.’’ In 2003, research emphasizes include network
‘‘trust’’ (security, reliability, and privacy); high-assurance software and systems; micro- and embedded sensor technologies; revolutionary architectures to reduce
the cost, size, and power requirements of high end computing platforms; and social and economic impacts of
information technology.
Nanotechnology R&D: The budget provides $679
million for the multi-agency National Nanotechnology
Initiative, a 17 percent increase over 2002. The initiative focuses on long-term research on the manipulation
of matter down to the atomic and molecular levels,
giving us unprecedented building blocks for new classes
of devices as small as molecules and machines as small
as human cells. This research could lead to continued
improvement in electronics for information technology;
higher-performance, lower-maintenance materials for
defense, transportation, space, and environmental applications; and accelerated biotechnical applications in
medicine, healthcare, and agriculture. In 2003, the initiative will focus on fundamental nanoscale research
through investments in investigator-led activities, centers and networks of excellence, as well as the supporting infrastructure. Priority areas include: research
to enable efficient nanoscale manufacturing; innovative
nanotechnology solutions for detection of and protection
from biological-chemical-radiological-explosive agents;
the education and training of a new generation or workers for future industries; and partnerships and other
policies to enhance industrial participation in the
nanotechnology revolution. The convergence of
nanotechnology with information technology, modern biology and social sciences will reinvigorate discoveries
and innovation in many areas of the economy.
Climate Change R&D: In June 2001, the President
announced that the Administration’s climate change
policy will be science-based, and it will encourage research breakthroughs that lead to technological innovation. To advance and bring focus to climate change
science and technology, the President created two new
initiatives: the Climate Change Research Initiative
(CCRI) and the National Climate Change Technology
Initiative (NCCTI). The Administration committed to
funding high-priority areas where investments can
make a difference. These new initiatives will complement ongoing research funded under the U.S. Global
Change Research Program (USGCRP) and other related
technology research programs that address climate
change.
The USGCRP has existed for more than a decade,
and provides funding at nine different agencies for fundamental research on natural and human-induced

8. RESEARCH AND DEVELOPMENT FUNDING

changes in the global environment, with the goal of
attaining a more complete understanding of global climate change to better respond to the challenges it presents. In 2003, this program will continue, with a total
funding level of $1.7 billion, an increase of 3 percent
over the 2002 enacted level. The 2003 budget will pause
the development of follow-on NASA satellites, the largest single item in the USGCRP budget, consuming more
than half of total program funding. NASA will not start
new satellites until a review of the USGCRP, and its
relationship to the new CCRI, is complete.
In addition to increasing funding for USGCRP, the
budget requests $40 million in CCRI, to be shared
among five agencies (NOAA, NSF, NASA, DOE, and
USDA). This investment will begin to focus on answering key gaps in knowledge among those recently identified by the National Academy of Sciences in a report
from 2001: ‘‘Climate Change Science: An Analysis of
Some Key Questions.’’ This includes improving the capability of ‘‘integrating scientific knowledge, including
its uncertainty, into effective decision support systems.’’
CCRI will adopt performance metrics and deliverable
products useful to policymakers in a short time frame
(2–5 years).
The NCCTI will build on an existing base of research
and development in climate change technologies, primarily at DOE, EPA, and USDA. The budget requests
$40 million for NCCTI within the DOE budget. Specific
research areas are being identified through an interagency review process.
Agency R&D Highlights
Each federal agency conducts R&D in the context
of that agency’s unique mission, structure, and statutory requirements. Below are highlights of key R&D
programs in selected agencies in the 2003 budget. Table
8–3 shows the FS&T budget. As shown in Table 8–2,
these programs and those of other agencies are part
of the larger federal R&D portfolio.
National Institutes of Health: NIH comprises 25
Institutes and Centers whose collective mission is to
sponsor and conduct biomedical research and research
training that leads to better health for all Americans.
While NIH does conduct research in its own laboratories, a majority of its funding supports more than
50,000 scientists working in 2,000 institutions across
the United States. With the help of NIH grants, these
scientists have been making great advances in the detection and treatment of diseases. All NIH grants are
peer-reviewed and are funded based on their scientific
merit.
During the presidential campaign, the President
promised to double the budget of the NIH by 2003
to $27.3 billion, from the 1998 level of $13.6 billion.
The 2003 budget includes the final installment of $3.9
billion needed to fulfill the President’s commitment,
which will maximize the opportunity to expand scientific discovery by increasing the number of new research grants funded. With this increase, NIH will fur-

165
ther its efforts to support research on diseases that
affect the lives of all Americans. For example, the budget provides $5.5 billion for cancer-related research at
the National Cancer Institute and other NIH Institutes.
This NIH funding increase will also finance important research needed for the war against terrorism.
As the country faces new and dangerous bioterrorism
threats, the NIH will expand research on the effects
of bioterrorism attacks and develop treatments in the
event our Nation is ever attacked. The 2003 budget
provides $1.75 billion for bioterrorism research, including genomic sequencing of dangerous pathogens, development of improved anthrax vaccine, and laboratory
and research facilities construction and upgrades related to bioterrorism and Z-chip technology research.
With the ability to identify a vast number of molecular
signatures, the Z-chip can be used on the front line
of medical response for nearly instant diagnosis of a
wide array of biothreats or naturally occurring diseases,
saving precious time and therefore lives in the first
hours of a biological attack.
National Aeronautics and Space Administration: The 2003 budget provides $8.8 billion for FS&T
programs at NASA, an 8 percent increase over 2002.
The 2003 budget restructures under-performing programs and provides funding to address key issues including establishing a long-term strategy for planetary
exploration, emphasizing near-term results in climate
change research, prioritizing research on the International Space Station, lowering the cost of access to
space, and improving the safety and efficiency of the
Nation’s civil aviation system.
In Space Science, the 2003 budget of $3.4 billion discontinues NASA’s Outer Planets program due to substantial cost and schedule growth and redirects funding
to a revamped New Frontiers program of competitively
selected planetary missions focused on understanding
the origins and existence of life beyond Earth. The 2003
budget also supports investments in safe and reliable
nuclear power and nuclear-electric propulsion technologies to enable much faster and more frequent planetary investigations with greater science capabilities in
this decade and the next. The 2003 budget for Earth
Science ($1.6 billion) supports two important demonstrations—the National Polar-Orbiting Operational
Environmental Satellite System (NPOESS) Preparatory
Project and the Jason follow-on—which will measure
key variables that are needed to provide long-term, climate quality data to understand how the Earth’s climate is changing. In Biological and Physical Research,
the 2003 budget of $851 million will yield clear priorities for Space Station research and invests in space
radiation and space biology research initiatives that
will enable new space platforms through which biological and physical research can be pursued.
The 2003 budget continues planned increases in funding for NASA’s Space Launch Initiative ($759 million
in 2003), a high priority program that will lead to safer
and lower cost, commercial launch vehicles to replace
the Space Shuttle. The 2003 budget maintains key in-

166
vestments in technologies to improve aircraft safety and
to reduce congestion in the Nation’s civil aviation system ($220 million).
National Science Foundation: The 2003 budget
provides $5.0 billion, a 5 percent increase, for research
at NSF, whose broad mission is to promote science and
engineering research and education. The budget provides: $678 million for NSF’s lead role in NITRD, focusing on long-term computer science research and applications; $221 million for NSF’s lead role in the National
Nanotechnology Initiative; $15 million for NSF participation in the Climate Change Research Initiative—in
addition to $188 million for USGCRP—for research on
climate change risk management, understanding the
North American carbon cycle, and computer modeling;
$27 million (a $20 million increase) for NSF basic research programs in microbe genome sequencing and the
transmission of infectious diseases, two research areas
of importance in combating bioterrorism.
Based on NSF’s noted expertise and success in funding competitive research, the 2003 budget aims to improve the quality of a number of science and engineering programs by transferring them to NSF. The budget
transfers the National Oceanic and Atmospheric Administration’s Sea Grant program and the United
States Geological Survey’s toxic substances hydrology
research program to NSF, where merit-based competition will improve overall program effectiveness. These
transfers will take advantage of NSF’s competitive culture and demonstrated quality of results.
The President’s goal to improve the quality of math
and science education in Grades K–12 will be pursued
through the President’s Math and Science Partnerships
Initiative, which allows states to join with institutions
of higher education, particularly math and science departments, in strengthening math and science education. The initiative provides a mechanism to allow
scientists and engineers to be part of the solution in
improving grades K–12 education. Funding for the programs is proposed to increase by $40 million, to $200
million. The budget also aims to further attract the
most promising U.S. students into graduate level
science and engineering by increasing graduate stipends from $21,500 to $25,000 annually.
Department of Energy: The 2003 budget provides
$5.0 billion for FS&T at DOE. The budget proposes
$3.3 billion, a 1.5-percent increase over 2002, for DOE
Science programs, the Nation’s leading sponsor of research in the physical sciences. DOE has a special role
in supporting research in particle physics, nuclear physics, fusion energy sciences, chemistry of the radioactive
elements, nanoscience, genomic sequencing, and computational science. The Department also supports research that will reduce key scientific uncertainties inherent in climate change and carbon cycle models.
These basic science programs support the DOE’s applied missions in energy, national nuclear security and
environmental quality. The Department contributes to
national science stewardship, a cornerstone of the De-

ANALYTICAL PERSPECTIVES

partment’s mission, by operating a suite of 27 scientific
user facilities—such as x-ray light sources, fusion experiments, particle accelerators and colliders. Over
18,000 scientists from universities, industry and government agencies use these facilities every year. Consistent with the Administration’s emphasis on shifting
funds to higher priority programs, the budget redirects
funding to maintain operations at Fermi National Accelerator Laboratory.
The Department sponsors applied research and development programs with two primary interests. In the
national security area, DOE sponsors R&D that sustains the safety, reliability, and performance of the Nation’s nuclear weapons ($3.1 billion in 2003). Nonproliferation and verification research conducted by the
Department advances technologies for detection of nuclear weapons proliferation, nuclear explosion monitoring, and chemical and biological response. In the
energy area, DOE sponsors research in energy production and use, from fossil, nuclear, and renewable
sources. The Department has had success in reducing
the cost of renewable energy resources (wind, solar,
geothermal, and biomass), and it will continue R&D
efforts to make these energy sources more cost-competitive. Last year’s budget provided $150 million to existing coal research towards the President’s commitment
to spend $2 billion over ten years on clean coal research. In the 2003 budget, all coal programs are
brought under one umbrella—the President’s Clean
Coal Research Initiative. Using a more transparent
budget structure, this approach will improve the management and oversight of this $326 million program.
DOE also sponsors R&D to improve the energy efficiency of buildings, industry, the transportation sector,
and the federal government ($589 million in 2003).
DOE’s energy conservation efforts include the following
examples. Cost-shared R&D with industry will to continue to increase industrial output per unit of energy
input. Development of a web-based tool will assist contractors and homeowners in identifying the most efficient energy-saving retrofit activities, based on the age
and condition of the home and the funds available.
A partnership with the trucking industry will dramatically improve fuel efficiency by 2010. And, a program
to increase energy efficiency in federal buildings will
achieve a 35 percent efficiency increase by 2010, compared to 1985 levels.
Department of Defense: DOD funds a wide range
of R&D to ensure that our military forces have the
tools to protect the Nation’s security. DOD’s 2003 budget includes $5.0 billion that appears in the FS&T budget.
Due in part to the events of September 11, 2001,
research and development of technologies and systems
that address terrorist threats have been the focus of
additional funds and urgency. Systems or technologies
under development include: improved detectors of chemical and biological threats (for both remote and onsite application); more comfortable and more effective
troop protective gear for use under chemical and bio-

8. RESEARCH AND DEVELOPMENT FUNDING

logical attack; vaccines to provide protection against
biological agents; surveillance systems to provide longer
range and earlier warning of possible attacks using
weapons of mass destruction; and more effective cave
and other ‘‘hard target’’ attack munitions.
DOD’s ‘‘Science and Technology’’ programs (over $9
billion in 2003) range from basic research and applied
research (included in FS&T), to fabrication of component prototypes for potential future systems. These programs explore and develop technical options for new
defense systems and help reduce the chance of being
surprised by new technologies in the hands of adversaries. Areas of emphasis include computing and communications, sensors, nanotechnology, understanding
the military environment (for example, oceans, atmospheric and geological sciences), propulsion systems, and
technologies for the next generation of long-range strike
aircraft. Promising technologies and processes may be
incorporated into weapon systems of the future.
Later stage development, test and evaluation funds
($45 billion) support development of new weapons and
supporting systems, including testing the effectiveness
of those systems and how they interface with other
weapons or control systems. Systems under development in 2003 include: the Joint Strike Fighter, ballistic
missile defense systems, a new aircraft carrier, the
DD(X) naval destroyer, space-based missile warning
satellites, and unmanned underwater vehicles. Systems
in the final stages of development include the F–22
fighter aircraft and the V–22 Osprey tilt-rotor aircraft.
The Army continues development efforts in support of
the Future Combat System as a major part of their
transformation to a lighter, more mobile, and more effective fighting force.
Department of Agriculture: The 2003 budget provides $1.9 billion, a one percent increase, for FS&T
at the Department of Agriculture (USDA). The budget
for USDA’s research, education and extension programs
proposes significant increases for high priority national
needs and for competitive, peer-reviewed grants, while
reducing or eliminating lower priority projects, particularly earmarks. Funded at $2.3 billion in 2003, this
program includes activities that are not part of the
FS&T budget, such as USDA laboratory construction
and rehabilitation, extension grants, and statistical programs. The 2003 budget adds $58 million to the programs of the Agricultural Research Service (ARS) in
the following areas: air and water quality and climate
change, biobased products, bioenergy and biotechnology,
protection against bioterrorism, emerging and exotic
diseases, genomics and genetics, and library resources.
In addition, the budget provides $240 million (a 100
percent increase) for the National Research Initiative
(NRI), which funds competitive research grants covering a broad spectrum of agricultural research areas.
The budget provides additional increases over 2002 of
$7 million for the expansion of the Agricultural Resources Management Study and of $15.5 million for
necessary cyclical costs associated with the five year
Census of Agriculture.

167
The 2003 budget for Forest Service Research and Development programs ($254 million) includes $10 million
for new priority research on biobased products and bioenergy and a quantitative planning and graphic data
analysis tool for forest planning. The budget also places
additional emphasis on annualized forest inventories.
In order to fund these increases and ensure that taxpayer dollars are used most effectively in the public
interest, the budget proposes to eliminate unrequested
earmarks for specific purposes at specific locations that
were provided in 2002. These total $205 million for
in-house research ($89 million in ARS and $16 million
in the Forest Service) and $123 million for research
grants, for a total of over 400 projects.
Department of the Interior: Within the Department
of the Interior (DOI), the 2003 budget provides $904
million for the United States Geological Survey (USGS),
for science that emphasizes the mission responsibility
of providing sound and impartial science to manage
land, water, biological, energy, and mineral resources.
The 2003 budget reduces direct federal funding for programs that support outside customers in order to increase the proportion of services paid for by these customers. The 2003 budget focuses resources on those
programs that directly address the science needs of Interior bureaus, including funding for science to support
ecosystem restoration in the Everglades. To support
sound conservation decisions, USGS will combine natural resource monitoring and information technology
that will promote conservation partnerships and better
inform federal, state, and local land acquisition.
The budget transfers USGS toxic substances hydrology research program funding to NSF. While the work
of USGS is generally of high quality, this transfer will
provide new emphasis on merit-based competitive selection. USGS will continue to play a role in identifying
research priorities.
Beginning in 2002, the Bureau of Land Management
and USGS will help support the development of the
E-Gov Geospatial One-Stop initiative. This initiative,
led by the interagency Federal Geographic Data Committee, will make geospatial data more accessible and
usable by developing government-wide data standards
and deploying a user friendly web portal for geospatial
data and mapping applications.
Department of Commerce: The 2003 budget provides $861 million for FS&T at the Department of Commerce (DOC). For the National Institute of Standards
and Technology (NIST), the budget provides $402 million—a 23 percent increase over 2002—for research and
physical improvements at NIST’s Measurement and
Standards Laboratories. In addition to funding ongoing
research, the budget increase supports construction of
new NIST facilities, including equipment for the Advanced Measurement Laboratory in Maryland. NIST
labs work with industry to develop the measurements
and standards needed to support technological innovation. Facilities modernization is needed to support
NIST’s groundbreaking research.

168
The 2003 budget also provides $107 million for
NIST’s Advanced Technology Program (ATP), which
makes R&D grants to commercial firms. In 2003, ATP
will modify its program regulations to increase university participation and allow cost-recoupment for successfully commercialized technologies.
The 2003 budget provides $297 million for FS&T at
the National Oceanic and Atmospheric Administration
(NOAA) to improve understanding of climate change,
weather and air quality, and ocean processes. In 2003,
NOAA’s R&D will also support economic growth
through continued efforts in marine biotechnology and
aquaculture, as well as a new initiative to demonstrate
benefits to the energy sector through improved weather
and river forecasting capabilities. The budget also
transfers the National Sea Grant College Program to
NSF to promote more rigorous, merit-based competition
among researchers. NOAA and NSF will jointly manage
the program, and NOAA will continue to play a role
in identifying research priorities.
Environmental Protection Agency: The budget
provides $797 million for FS&T at the Environmental
Protection Agency (EPA). The Office of Research and
Development (ORD) performs the majority of EPA’s research and provides a sound scientific and technical
foundation for environmental policy and regulatory decision-making. EPA relies on strong science to achieve
its mission and has a responsibility to ensure that efforts to reduce environmental risks are based on the
best available scientific information. In 2003, EPA will
work to improve methods for assessing the cumulative
risks of complex pollutant mixtures, tools to describe
the impact of exposures to them on cumulative risk,
and the tools for decision makers to address cumulative
risks. EPA will also focus essential scientific support
on its highest-priority pending regulations to help
strengthen its regulatory process. A new EPA effort
to identify innovative environmental technologies
through a national competition is expected to help solve
such vexing problems as effluent trading programs and
removing arsenic from drinking water. EPA will also
fund a new biotechnology research effort to address
information gaps and develop management tools for
allergenicity, and ecological risk and resistance. The
budget includes $75 million for research into technologies and procedures to cope with future biological
or chemical incidents.
Department of Transportation: The 2003 budget
provides $548 million for FS&T at the Department of
Transportation (DOT). DOT research funds are concentrated primarily in the federal Highway Administration (FHWA), the National Highway Traffic Safety Administration (NHTSA), and the Federal Airline Administration (FAA). The FHWA ($421 million in 2003) supports research to improve the quality and safety of the
Nation’s transportation infrastructure. Specifically, the
research focuses on methods to increase the quality
and longevity of roadways, identifies safety improvements possible through the use of Intelligence Trans-

ANALYTICAL PERSPECTIVES

portation Systems (ITS), and analyzes the use of surveillance technology for improved traffic control, emergency evacuations and critical infrastructure. NHTSA’s
2003 budget provides $58 million for R&D in crash
worthiness, crash avoidance and data analysis to help
reduce highway fatalities and injuries.
In aviation research, and in light of the September
11th terrorist attacks, security will be the major focus
for the FAA as it develops the best technologies to
prevent future incidents. The 2003 budget provides $95
million for aviation security technology research.
Department of Education: The 2003 budget provides $431 million for FS&T at the Department of Education. The vast majority of the Department’s research
and development is administered by three offices: the
Office of Educational Research and Improvement
(OERI), National Institute for Disability and Rehabilitation Research (NIDRR), and the Office of Special Education Programs (OSEP).
OERI, which administers the largest share of FS&T
funds through Research, Development, and Dissemination, conducts research on teaching, learning and
achievement; develops materials and methods to help
students succeed; and disseminates these techniques to
teachers and schools. In 2003, OERI’s research portfolio
will include a program that builds on the substantial
science of reading to study conditions under which children decode and ultimately comprehend what they
read. A second new program will support trials of existing preschool curricula to identify which work best. A
third will identify strategies to enhance the use of research findings by teachers, school administrators, and
policymakers.
The Administration is developing a reauthorization
proposal for OERI that will address many of its perennial research quality issues through structural reform.
The new structure should allow OERI to improve the
quality, objectivity, coordination, and focus of the Department’s research activities. Until reauthorizing legislation is enacted, the Assistant Secretary is improving
the scientific quality of OERI-funded research projects
through implementation of a more rigorous grant solicitation and peer review process.
The Office of Special Education and Rehabilitative
Services administers R&D related to persons with disabilities through NIDRR and OSEP. NIDRR conducts
research and related activities to maximize the full integration, employment, and independent living of individuals with disabilities, consistent with the President’s
New Freedom Initiative, which aims to help individuals
with disabilities lead more independent lives.
OSEP supports special education research projects,
demonstrations, and outreach in order to produce new
knowledge in the fields of special education and early
intervention, apply effective research in model demonstration projects, and put knowledge into the hands
of those who work with children with disabilities.
Department of Veterans Affairs: The 2003 budget
provides $409 million for FS&T at the Department of

169

8. RESEARCH AND DEVELOPMENT FUNDING

Veterans Affairs (VA), an increase of 10 percent. In
addition, the Department receives significant funding
from other governmental agencies and private entities
to support VA-conducted research, which brings the
total of R&D VA performs to $1.4 billion. The 2003
budget provides $394 million for clinical, epidemiological, and behavioral studies across a broad spectrum
of medical research disciplines. Among the agency’s top
research priorities are improving the translation of research results into patient care, special populations
(those afflicted with spinal cord injury, visual and hearing impairments, and serious mental illness), geriatrics,
diseases of the brain (e.g., Alzheimer’s and Parkinson’s
disease), treatment of chronic progressive multiple sclerosis, and chronic disease management.

actively reinstated for five years, to 2004, in the Tax
Relief Extension Act of 1999. The budget proposes to
make the Research and Experimentation (R&E) tax
credit permanent. The proposed extension will cost $14
billion over the period from 2004 to 2007. In addition,
a permanent tax provision lets companies deduct, up
front, the costs of certain kinds of research and experimentation, rather than capitalize these costs. Finally,
equipment used for research benefits from relatively
rapid cost recovery.
Table 8–1 shows a forecast of the costs of the tax
credit.

Stimulating Private Investment

(Budget authority, dollar amounts in millions)

Along with direct spending on R&D, the federal government has sought to stimulate private investment
in these activities with tax preferences. The current
law provides a 20-percent tax credit for private research
and experimentation expenditures above a certain base
amount. The credit, which expired in 1999, was retroIV.

Table 8–1.

PERMANENT EXTENSION OF THE RESEARCH AND
EXPERIMENTATION TAX CREDIT
2003

2004

2005

2006

2007

2003–2007

Current Law ............................
Proposed Extension ................

4,590
0

4,020
906

2,330
2,949

990
4,654

410
5,623

12,350
14,132

Total ...............................

4,590

4,926

5,279

5,644

6,033

26,482

FEDERAL R&D DATA

Federal R&D Funding
R&D is the collection of efforts directed towards gaining greater knowledge or understanding and applying
knowledge toward the production of useful materials,
devices, and methods. R&D investments can be characterized as basic research, applied research, development, R&D equipment, or R&D facilities, and OMB
has used those or similar categories in its collection
of R&D data since 1949.
Basic research is defined as systematic study directed toward greater knowledge or understanding of
the fundamental aspects of phenomena and of observable facts without specific applications towards processes or products in mind.
Applied research is systematic study to gain knowledge or understanding necessary to determine the
means by which a recognized and specific need may
be met.
Development is systematic application of knowledge
toward the production of useful materials, devices, and
systems or methods, including design, development, and

improvement of prototypes and new processes to meet
specific requirements.
Research and development equipment includes acquisition or design and production of movable equipment, such as spectrometers, microscopes, detectors,
and other instruments.
Research and development facilities include the
acquisition, design, and construction of, or major repairs or alterations to, all physical facilities for use
in R&D activities. Facilities include land, buildings, and
fixed capital equipment, regardless of whether the facilities are to be used by the Government or by a private organization, and regardless of where title to the
property may rest. This category includes such fixed
facilities as reactors, wind tunnels, and particle accelerators.
There are over twenty federal agencies that fund
R&D in the U.S. The nature of the R&D that these
agencies fund depends on the mission of each agency
and on the role of R&D in accomplishing it. Table 8–2
shows agency-by-agency spending on basic and applied
research, development, and R&D equipment and facilities.

170

ANALYTICAL PERSPECTIVES

Table 8–2.

FEDERAL RESEARCH AND DEVELOPMENT SPENDING
(Budget authority, dollar amounts in millions)
2000 Actual

2001 Actual

2002 Estimate

2003 Proposed

Dollar Change:
2002 to 2003

Percent Change:
2002 to 2003

By Agency
Defense ..........................................................................................
Health and Human Services .........................................................
National Aeronautics and Space Administration ...........................
Energy ............................................................................................
National Science Foundation .........................................................
Agriculture ......................................................................................
Commerce ......................................................................................
Veterans Affairs ..............................................................................
Transportation ................................................................................
Environmental Protection Agency ..................................................
Interior ............................................................................................
Education ........................................................................................
Other ...............................................................................................

39,664
18,051
9,242
6,892
2,947
1,773
1,110
618
603
559
645
238
796

42,235
21,037
9,675
7,772
3,363
2,182
1,054
748
792
598
622
264
922

49,171
23,938
9,560
9,253
3,571
2,336
1,129
796
867
612
660
268
1,021

54,544
27,683
10,069
8,510
3,700
2,118
1,114
846
725
650
628
311
858

5,373
3,745
509
–743
129
–218
–15
50
–142
38
–32
43
–163

11%
16%
5%
–8%
4%
–9%
–1%
6%
–16%
6%
–5%
16%
–16%

Total ...........................................................................................

83,138

91,264

103,182

111,756

8,574

8%

Basic Research
Defense ..........................................................................................
Health and Human Services .........................................................
National Aeronautics and Space Administration ...........................
Energy ............................................................................................
National Science Foundation .........................................................
Agriculture ......................................................................................
Commerce ......................................................................................
Veterans Affairs ..............................................................................
Transportation ................................................................................
Environmental Protection Agency ..................................................
Interior ............................................................................................
Education ........................................................................................
Other ...............................................................................................

1,136
10,062
2,137
2,262
2,540
684
42
52
10
58
266
2
170

1,271
11,601
1,652
2,390
2,894
801
50
301
17
105
56
2
190

1,305
13,183
1,909
2,420
3,093
860
52
344
13
107
58
2
196

1,336
14,467
2,298
2,517
3,242
880
73
367
25
101
55
1
183

31
1,284
389
97
149
20
21
23
12
–6
–3
–1
–13

2%
10%
20%
4%
5%
2%
40%
7%
92%
–6%
–5%
–50%
–7%

Subtotal .....................................................................................

19,421

21,330

23,542

25,545

2,003

9%

Applied Research
Defense ..........................................................................................
Health and Human Services .........................................................
National Aeronautics and Space Administration ...........................
Energy ............................................................................................
National Science Foundation .........................................................
Agriculture ......................................................................................
Commerce ......................................................................................
Veterans Affairs ..............................................................................
Transportation ................................................................................
Environmental Protection Agency ..................................................
Interior ............................................................................................
Education ........................................................................................
Other ...............................................................................................

3,405
7,692
1,534
1,874
184
831
780
520
396
388
367
151
344

3,673
9,064
2,533
2,330
181
1,045
768
432
445
370
534
172
413

3,656
10,249
2,766
2,874
192
988
838
436
522
381
570
178
432

3,616
12,379
3,099
2,866
199
946
795
462
396
431
541
212
348

–40
2,130
333
–8
7
–42
–43
26
–126
50
–29
34
–84

–1%
21%
12%
0%
4%
–4%
–5%
6%
–24%
13%
–5%
19%
–19%

Subtotal .....................................................................................

18,466

21,960

24,082

26,290

2,208

9%

Development
Defense ..........................................................................................
Health and Human Services .........................................................
National Aeronautics and Space Administration ...........................
Energy ............................................................................................
National Science Foundation .........................................................
Agriculture ......................................................................................
Commerce ......................................................................................
Veterans Affairs ..............................................................................
Transportation ................................................................................
Environmental Protection Agency ..................................................
Interior ............................................................................................
Education ........................................................................................
Other ...............................................................................................

35,026
44
2,702
1,855
0
111
130
29
185
92
12
85
253

37,270
107
2,698
2,042
0
152
170
15
247
101
32
90
306

44,200
129
2,582
2,851
0
163
162
16
256
103
32
88
378

49,570
100
2,648
2,162
0
156
109
17
221
97
32
98
310

5,370
–29
66
–689
0
–7
–53
1
–35
–6
0
10
–68

12%
–22%
3%
–24%
N/A
–4%
–33%
6%
–14%
–6%
0%
11%
–18%

Subtotal .....................................................................................

40,524

43,230

50,960

55,520

4,560

9%

Facilities and Equipment
Defense ..........................................................................................
Health and Human Services .........................................................

97
253

21
265

10
377

22
737

12
360

120%
95%

171

8. RESEARCH AND DEVELOPMENT FUNDING

Table 8–2.

FEDERAL RESEARCH AND DEVELOPMENT SPENDING—Continued
(Budget authority, dollar amounts in millions)
2000 Actual

2001 Actual

2002 Estimate

2003 Proposed

Dollar Change:
2002 to 2003

Percent Change:
2002 to 2003

National Aeronautics and Space Administration ...........................
Energy ............................................................................................
National Science Foundation .........................................................
Agriculture ......................................................................................
Commerce ......................................................................................
Veterans Affairs ..............................................................................
Transportation ................................................................................
Environmental Protection Agency ..................................................
Interior ............................................................................................
Education ........................................................................................
Other ...............................................................................................

2,869
901
223
147
158
17
12
21
0
0
29

2,792
1,010
288
184
66
0
83
22
0
0
13

2,303
1,108
286
325
77
0
76
21
0
0
15

2,024
965
259
136
137
0
83
21
0
0
17

–279
–143
–27
–189
60
0
7
0
0
0
2

–12%
–13%
–9%
–58%
78%
N/A
9%
0%
N/A
N/A
13%

Subtotal .....................................................................................

4,727

4,744

4,598

4,401

–197

–4%

Federal Science and Technology Budget
Table 8–3 contains the FS&T budget, which accounts
for nearly all of federal basic research, over 80 percent
Table 8–3.

of federal applied research, and about half of civilian
development.

FEDERAL SCIENCE AND TECHNOLOGY BUDGET
(Budget authority, dollar amounts in millions)
2000 Actual

By Agency
National Institutes of Health 1 ...................................................................
NASA 2 ..........................................................................................................
Space Science .........................................................................................
Earth Science ...........................................................................................
Biological and Physical Research ...........................................................
Aero-space Technology ...........................................................................
National Science Foundation ....................................................................
Energy ..........................................................................................................
Science Programs 3 ..................................................................................
Renewable Energy ...................................................................................
Nuclear Energy ........................................................................................
Energy Conservation 4 .............................................................................
Fossil Energy 5 .........................................................................................
Defense ........................................................................................................
Basic Research ........................................................................................
Applied Research .....................................................................................
Agriculture ...................................................................................................
CSREES Research and Education .........................................................
Economic Research Service ....................................................................
Mandatory Research Grants 6 .................................................................
Agricultural Research Service 7 ...............................................................
Forest Service 8 ........................................................................................
Interior (USGS) ............................................................................................
Commerce ...................................................................................................
NOAA (Oceanic and Atmospheric Research) 9 ......................................
NIST 10 ......................................................................................................
Environmental Protection Agency 11 ........................................................
Transportation .............................................................................................
Highway research 12 .................................................................................
Aviation research 13 ..................................................................................
Education .....................................................................................................
Special Education Research and Innovation ..........................................
NIDRR 14 ..................................................................................................
Research, Development, and Dissemination ..........................................

17,827
7,013
2,606
1,734
839
1,834
3,903
4,338
2,820
306
226
577
409
4,541
1,136
3,405
1,759
488
67
120
866
218
847
826
285
541
683
593
490
103
317
64
86
167

2001 Actual

20,438
7,789
2,760
1,825
944
2,260
4,437
4,911
3,218
370
261
619
443
4,944
1,271
3,673
1,885
514
69
120
936
246
918
828
325
503
746
521
387
134
363
77
100
186

2002 Estimate

23,433
8,113
3,034
1,695
828
2,556
4,795
5,099
3,240
386
244
641
588
4,961
1,305
3,656
1,890
552
70
0
1,017
251
950
948
362
586
750
651
448
203
377
78
110
189

2003 Proposed

27,335
8,774
3,428
1,639
851
2,856
5,036
5,027
3,285
408
251
589
494
4,952
1,336
3,616
1,913
563
82
0
1,014
254
904
861
297
564
797
548
421
127
431
78
110
243

Dollar Change:
2002 to 2003

3,902
661
394
-56
23
300
241
-72
45
22
7
-52
-94
-9
31
-40
23
11
12
0
-3
3
-46
-87
-65
-22
47
-103
-27
-76
54
0
0
54

Percent Change:
2002 to 2003

17%
8%
13%
-3%
3%
12%
5%
-1%
1%
6%
3%
-8%
-16%
0%
2%
-1%
1%
2%
17%
N/A
0%
1%
-5%
-9%
-18%
-4%
6%
-16%
-6%
-37%
14%
0%
0%
29%

172

ANALYTICAL PERSPECTIVES

Table 8–3.

FEDERAL SCIENCE AND TECHNOLOGY BUDGET—Continued
(Budget authority, dollar amounts in millions)
2000 Actual

Veterans Affairs 15 ......................................................................................
Total ........................................................................................................

2001 Actual

2002 Estimate

2003 Proposed

Dollar Change:
2002 to 2003

Percent Change:
2002 to 2003

321

363

373

409

36

10%

42,968

48,143

52,340

56,987

4,647

9%

Notes: Levels adjusted to include the full share of accruing employee pensions and annuitants health benefits. For more information on these items, please see Chapter 14. Levels for 2000 are derived without accrual in most instances.
1 The 2002 appropriation includes $100 million for the Global Fund to Fight HIV/AIDS, Turberculosis, and Malaria.
2 All years normalized to reflect 2003 transfers of funding for Space Station research facilities, space communications activities, and associated institutional support from human space flight.
3 Includes $36 million for programs transferred from Environmental Management.
4 Excludes state grant programs.
5 Excludes balances tranferred from the Clean Coal Technology program for activities in 2001 ($95 million), 2002 ($34 million), and 2003 ($40 million).
6 Initiative for Future Agriculture and Food Systems.
7 Excludes buildings and facilities.
8 Forest and Rangeland Research.
9 Excludes Manufacturing Extension Program.
10 The 2003 level does not include the Sea Grant program, which was transferred to NSF.
11 Science and Technology, plus superfund transfer. The 2002 level does not include anti-terrorism supplemental funding, which is primarily for drinking water vulnerability standards. The 2003 level
includes an additional superfund transfer for security research related to building decontamination.
12 Includes research and development funding for the Federal Highway Administration, the Federal Motor Carrier Safety Administration, and the National Highway Traffic Safety Administration.
13 Federal Aviation Administration Research, Engineering, and Development. Excludes funding for aviation security research in all years, now funded through the Transportation Security Administration.
14 National Institute on Disability and Rehabilitation Research.
15 Medical and Prosthetic Research.

Interagency R&D Efforts

Nanotechnology Initiative, and the climate change research and technology initiatives.

Table 8–4 shows agency spending for Networking and
Information
Technology
R&D,
the
National

Table 8–4.

AGENCY DETAIL OF SELECTED INTERAGENCY R&D EFFORTS
(Budget authority, dollar amounts in millions)
2001 Actual

Networking and Information Technology R&D
National Science Foundation ................................................................
Health and Human Services .................................................................
Energy ....................................................................................................
Defense ..................................................................................................
National Aeronautics and Space Administration ..................................
Commerce .............................................................................................
Environmental Protection Agency .........................................................

2002 Estimate

Dollar Change: 2002
to 2003

2003 Proposed

Percent Change: 2002
to 2003

636
277
326
310
177
38
4

676
310
312
320
181
43
2

678
336
313
306
213
42
2

2
26
1
–14
32
–1
0

0%
8%
0%
–4%
18%
–2%
0%

Total ..................................................................................................
National Nanotechnology Initiative
National Science Foundation ................................................................
Defense ..................................................................................................
Energy ....................................................................................................
Commerce .............................................................................................
National Institutes of Health ..................................................................
National Aeronautics and Space Administration ..................................
Environmental Protection Agency .........................................................
Department of Transportation ...............................................................
Department of Justice ...........................................................................

1,768

1,844

1,890

46

3%

150
125
88
33
40
22
5
0
1

199
180
91
38
41
22
5
2
1

221
201
139
44
43
22
5
2
1

22
21
48
6
2
0
0
0
0

11%
12%
53%
16%
6%
0%
0%
0%
0%

Total ..................................................................................................
Climate Change Research Initiative.
Commerce .............................................................................................
National Science Foundation ................................................................
National Aeronautics and Space Administration ..................................
Energy ....................................................................................................
Agriculture ..............................................................................................

464

579

679

100

17%

0
0
0
0
0

0
0
0
0
0

18
15
3
3
1

18
15
3
3
1

N/A
N/A
N/A
N/A
N/A

Total ..................................................................................................
U.S. Global Change Research Program
National Aeronautics and Space Administration ..................................
National Science Foundation ................................................................
Energy ....................................................................................................

0

0

40

40

N/A

1,176
181
116

1,090
188
120

1,109
188
126

19
0
6

2%
0%
5%

173

8. RESEARCH AND DEVELOPMENT FUNDING

Table 8–4.

AGENCY DETAIL OF SELECTED INTERAGENCY R&D EFFORTS—Continued
(Budget authority, dollar amounts in millions)
2001 Actual

2002 Estimate

Dollar Change: 2002
to 2003

2003 Proposed

Percent Change: 2002
to 2003

Commerce .............................................................................................
National Institutes of Health ..................................................................
Agriculture ..............................................................................................
Interior ....................................................................................................
Environmental Protection Agency .........................................................
Smithsonian ...........................................................................................

93
54
51
27
23
7

100
60
56
28
21
7

100
68
66
28
22
7

0
8
10
0
1
0

0%
13%
18%
0%
5%
0%

Total ..................................................................................................

1,728

1,670

1,714

44

3%

* Includes $9 million in offsetting collections in 2003 for the Agency for Healthcare Research and Quality. These activities were funded at $15 million in 2001 and $14 million in 2002.

Allocation of Research Funding
Federal funds appropriated to Executive Branch
agencies may be used in different ways, ranging from
grants awarded to university researchers to supporting
research at federal laboratories. The Administration
supports the competitive, merit review process for funding research in most cases. However, there are appropriate roles for other modes of allocating research funding in some circumstances, such as funding research
at specific facilities that have unique capabilities.
In order to better understand and characterize the
methods agencies use to allocate their research funding,
agencies reported how research funds are allocated by
the following five categories:
Research performed at congressional direction
consists of intramural and extramural research programs where funded activities are awarded to a single
performer or collection of performers with limited or
no competitive selection or with competitive selection
but outside of the agency’s primary mission, based on
direction from the Congress in law, in report language,
or by other direction.
Inherently unique research is intramural and extramural research programs where funded activities are
awarded to a single performer or team of performers
without competitive selection. The award may be based
on the provision of unique capabilities, concern for timeliness, or prior record of performance (e.g., facility operations support for a unique facility, such as an electronpositron linear collider; research grants for rapid response studies such as Pfisteria, an environmental hazard that arose suddenly).
Merit-reviewed research with limited competitive
selection is intramural and extramural research pro-

grams where funded activities are competitively awarded from a pool of qualified applicants that are limited
to organizations that were created to largely serve federal missions and continue to receive most of their annual research revenue from federal sources. The limited
competition may be for reasons of stewardship, agency
mission constraints, or retention of unique technical
capabilities (e.g., funding set aside for researchers at
laboratories or centers of DOD, NASA, EPA, NOAA,
and NIH; Federally-Funded Research and Development
Centers; formula funds for USDA).
Merit-reviewed research with competitive selection and internal (program) evaluation is intramural and extramural research programs where funded
activities are competitively awarded following review
for scientific or technical merit. The review is conducted
by the program manager or other qualified individuals
from within the agency program, without additional
independent evaluation (e.g., merit-reviewed research
at DOD).
Merit-reviewed research with competitive selection and external (peer) evaluation is intramural
and extramural research programs where funded activities are competitively awarded following review by a
set of external scientific or technical reviewers (often
called peers) for merit. The review is conducted by appropriately qualified scientists, engineers, or other technically-qualified individuals who are apart from the
people or groups making the award decisions, and
serves to inform the program manager or other qualified individual who makes the award (e.g., NSF’s single-investigator research; NASA’s research and analysis
funds).
Table 8–5 lists how federal R&D agencies report allocating research funding among these categories.

174

ANALYTICAL PERSPECTIVES

Table 8–5.

ALLOCATION OF FEDERAL RESEARCH FUNDING, 2001 and 2002
(Budget authority, dollar amounts in millions)

Research
Performed at
Congressional
Direction
2001

2002

Inherently Unique
Research

Merit-Reviewed
Research with
Limited
Competitive
Selection

Merit-Reviewed
Research with
Competitive
Selection and
Internal Evaluation

2001

2002

2001

2002

2001

2002

Merit-Reviewed
Research with
Competitive
Selection and
External
Evaluation
2001

2002

Total
2001

2002

By Agency
Health and Human Services ...................................
Energy ......................................................................
Defense * ..................................................................
National Aeronautics and Space Administration .....
National Science Foundation ...................................
Agriculture ** .............................................................
Commerce ................................................................
Veterans Affairs ........................................................
Interior ......................................................................
Transportation ..........................................................
Environmental Protection Agency ............................
Education ..................................................................
Smithsonian Institution .............................................
Other .........................................................................

89
134
678
230
0
105
18
1
27
55
39
5
0
385

142
223
426
287
0
122
21
0
48
82
60
0
0
413

206
1,078
295
152
0
815
354
0
156
69
39
0
108
11

230
1,068
350
149
0
893
377
0
154
73
38
0
111
7

2,392
2,382
1,012
532
191
720
100
2
379
0
195
0
0
17

2,718
2,820
1,014
398
206
676
108
2
392
0
192
0
0
17

201
305
2,712
1,377
184
0
204
349
26
338
69
0
0
76

216 17,777 20,126 20,665 23,432
395
821
788 4,720 5,294
2,950
247
221 4,944 4,961
1,550 1,894 2,291 4,185 4,675
192 2,700 2,887 3,075 3,285
0
206
157 1,846 1,848
218
142
166
818
890
370
381
408
733
780
31
2
3
590
628
380
0
0
462
535
68
133
130
475
488
0
169
180
174
180
0
0
0
108
111
74
6
6
495
517

Total .....................................................................

1,766

1,824

3,283

3,450

7,922

8,543

5,841

6,444 24,478 27,363 43,290 47,624

* Allocation among categories is preliminary.
** Does not include net mandatory funding for USDA research grant programs of $120 million in FY 2001.

Earmarks
Table 8–6 lists the top 30 recipients of individual
academic earmarks in 2001, as identified by The Chronicle of Higher Education. In addition to $1.2 billion
in earmarks to specific colleges and universities, there

Table 8–6.

is another $431 million in earmarked funding to be
shared in an unspecified distribution among these and
other colleges and universities.
Table 8–6. 30 Colleges and Universities Received
Over 40 Percent of Unshared* Academic Earmarks in
2001

COLLEGES AND UNIVERSITIES RECEIVED OVER 40 PERCENT OF UNSHARED* ACADEMIC
EARMARKS IN 2001

College or University

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.

University of Alaska at Fairbanks ........................................................................
Loma Linda University .........................................................................................
Marshall University ...............................................................................................
University of New Hampshire ..............................................................................
Dartmouth College ................................................................................................
University of Missouri at Columbia ......................................................................
University of Mississippi .......................................................................................
University of Alabama at Birmingham .................................................................
University of Nebraska .........................................................................................
Kansas State University .......................................................................................
University of Florida .............................................................................................
Mississippi State University .................................................................................
Pennsylvania State University at University Park ...............................................
Wheeling Jesuit University ...................................................................................
University of Maine ..............................................................................................
West Virginia University .......................................................................................
Auburn University .................................................................................................
University of South Carolina at Columbia ...........................................................
Southern Illinois University at Edwardsville .........................................................
University of Alabama at Tuscaloosa ..................................................................
University of South Florida ..................................................................................
University of Minnesota—Twin Cities ..................................................................
University of Louisville .........................................................................................

State

Alaska
California
West Virginia
New Hampshire
New Hampshire
Missouri
Mississippi
Alabama
Nebraska
Kansas
Florida
Mississippi
Pennsylvania
West Virginia
Maine
West Virginia
Alabama
South Carolina
Illinois
Alabama
Florida
Minnesota
Kentucky

Number of
Earmarks
Received

20
4
6
14
5
21
20
12
4
12
14
33
14
9
9
17
17
6
3
10
8
5
9

Sum of
Earmarks*
(millions)

$35.0
$35.0
$27.6
$27.5
$25.9
$23.7
$23.7
$22.1
$19.5
$18.3
$18.3
$18.2
$16.7
$16.3
$16.2
$15.6
$15.2
$14.6
$14.3
$14.2
$13.2
$12.7
$12.5

175

8. RESEARCH AND DEVELOPMENT FUNDING

Table 8–6.

COLLEGES AND UNIVERSITIES RECEIVED OVER 40 PERCENT OF UNSHARED* ACADEMIC
EARMARKS IN 2001—Continued

College or University

24.
25.
26.
27.
28.
29.
30.

New Mexico Institute of Mining and Technology ................................................
University of Southern Mississippi .......................................................................
Montana State University at Bozeman ................................................................
Washington State University ................................................................................
University of Hawaii, Manoa ................................................................................
Medical University of South Carolina ..................................................................
University of Miami ...............................................................................................

State

New Mexico
Mississippi
Montana
Washington
Hawaii
South Carolina
Florida

* Totals do not include earmarks split among institutions, where the distribution was not specified.

Number of
Earmarks
Received

7
11
17
18
20
3
4

Sum of
Earmarks*
(millions)

$12.5
$11.8
$11.1
$10.5
$10.4
$10.0
$9.5

9. CREDIT AND INSURANCE
Federal credit programs offer direct loans and loan
guarantees for a wide range of activities, primarily
housing, education, business and rural development,
and exports. At the end of 2001, there were $242 billion
in Federal direct loans outstanding and $1,084 billion
in loan guarantees. Through its insurance programs,
the Federal Government insures bank, thrift, and credit
union deposits up to $100,000, guarantees private defined-benefit pensions, and insures against other risks
such as natural disasters.
The Federal Government also enhances credit availability for targeted sectors indirectly through Government-sponsored enterprises (GSEs)—privately owned
companies and cooperatives that operate under Federal
charters. GSEs provide direct loans and increase liquidity by guaranteeing and securitizing loans. Some GSEs
have become major players in the financial market.
In 2001, the face value of GSE lending totaled $3.1
trillion. In return for serving social purposes, GSEs
enjoy some privileges, which include eligibility of their
securities to collateralize public deposits and be held
in unlimited amounts by most banks and thrifts, exemption of their securities from SEC registration, exemption of their earnings from State and local income
taxation, and ability to borrow from Treasury, at Treasury’s discretion, in amounts ranging up to $4 billion.
These privileges leave many people with the impression
that their securities are risk-free. GSEs, however, are
not part of the Federal Government, and their securities are not federally guaranteed. By law, the GSEs’
securities carry a disclaimer of any U.S. obligation.
The role and risk of these diverse programs critically
depend on the state of financial markets. In recent
I.

years, financial markets have been changing fast because of rapid technological advances and active deregulation. The Federal Government, therefore, needs
to reassess the extent and nature of credit and insurance programs more carefully in order to adapt those
programs to rapidly changing financial markets.
The rest of this chapter is organized as follows.
• The first section analyzes the role of Federal credit and insurance programs. Federal programs play
useful roles when market imperfections prevent
the private market from efficiently providing credit and insurance. Financial evolution has partly
corrected many imperfections and generally weakened the justification for Federal intervention.
• The second section identifies four key criteria for
evaluating Federal programs: objectives, economic
justification, availability of alternative means, and
efficiency. Recognizing that improving efficiency is
an everlasting concern, this section pays particular attention to the issue, and also discusses
Federal loan sales as a special issue in improving
efficiency.
• The third section reviews Federal credit programs
and GSEs in four sectors: housing, education,
business and community development, and exports. This section discusses program objectives,
recent developments, and future plans for each
program.
• The final section describes Federal deposit insurance, pension guarantees, and disaster insurance
in a context similar to that for credit programs.

FEDERAL PROGRAMS IN CHANGING FINANCIAL MARKETS

The Federal Role
The roles of Federal credit and insurance programs
can be broadly classified into two areas: helping disadvantaged groups and correcting market failures. Subsidized Federal credit programs redistribute resources
from the general taxpayer to disadvantaged regions or
segments of the population. Since disadvantaged groups
can be assisted through other means, such as direct
subsidies, the value of a credit or insurance program
critically depends on the extent to which it corrects
market failures.
In most cases, private lending and insurance business
efficiently meets societal demands by allocating resources to the most productive uses, and Federal intervention is unnecessary or can even be distortionary.
However, Federal intervention may improve the market
outcome in some situations. The market imperfections

that justify some Federal involvement can be broadly
classified as follows.
• Information opaqueness interferes with the optimal allocation of capital. In most cases, financial
intermediaries efficiently gather and process information needed to evaluate the creditworthiness
of borrowers. However, there may be little objective information about some groups of borrowers
such as start-up businesses, start-up farmers, and
students, who have limited incomes and credit histories. Because it is difficult for those borrowers
to prove their creditworthiness to a large number
of lenders, they must rely on the subjective judgements of a few lenders. In this situation, many
creditworthy borrowers may fail to obtain credit.
Even for borrowers who are approved for credit,
insufficient competition can result in higher inter-

177

178
est rates. Government intervention, such as loan
guarantees, enable these groups of borrowers to
obtain credit more easily and cheaply and provides
an opportunity for the lender to become more comfortable with that group of borrowers. Similarly,
the private sector efficiently insures against various risks. Insurance companies estimate the expected loss based on probabilities of loss-generating events and charge adequate premiums. Private insurers, however, are reluctant to insure
against an event for which they cannot reasonably
estimate the probability and the magnitude of
loss. Without these estimates, they cannot adequately set the premium. Terrorism emerged as
one of these cases after the September 11 attacks.
In these cases, Government intervention limiting
uncertainties for the private sector may be necessary to ensure the provision of insurance.
• Externalities cause either underinvestment or
overinvestment in some sectors. Individuals and
private entities do not make socially optimal decisions when they do not capture the full benefit
(positive externalities) or bear the full cost (negative externalities) of their activities. Examples of
positive and negative externalities are education
and pollution. The general public benefits from
high productivity and good citizenship of a welleducated person and suffers from pollution. Without Government intervention, people will invest
less than the socially optimal amount in activities
that generate positive externalities and more in
activities that generate negative externalities. The
Federal Government can encourage activities involving positive externalities by offering subsidized credit or other rewards such as tax benefits and discourage activities involving negative
externalities by imposing taxes or other penalties.
Alternatively, the Government may offer credit or
direct subsidies to encourage activities reducing
negative externalities (e.g., pollution control).
• Resource constraints sometimes limit the private sector’s ability to offer certain products. Deposit insurance is one example. Since the performance of banks is often affected by common factors
such as macroeconomic conditions, bank failures
tend to be clustered in bad economic times. Furthermore, if depositors become doubtful about the
soundness of the banking system as a whole upon
observing a large number of failures, they may
rush to withdraw deposits, forcing even sound
banks into liquidation. To prevent these undesirable withdrawals, which would harm the whole
economy, deposit insurance needs to be backed
by a sufficient fund to resolve a very large number
of failures. It may be difficult for private insurers
to secure such a large fund. Some catastrophic
events can also threaten the solvency of private
insurers. For some events involving a small risk
of a very large loss, therefore, Government insurance commanding more resources can be more

ANALYTICAL PERSPECTIVES

credible and effective. Another form of resource
constraint is a liquidity constraint. It is usually
difficult for a private entity to raise a large
amount in a short time. The funding difficulty
can limit the private market’s ability to extend
credit and thereby disrupt economic activity. The
Federal Government can prevent economic disruption by providing liquidity in illiquid sectors or
during illiquid periods.
• Imperfect competition justifies some Government intervention. Competition is imperfect in
some markets because of barriers to entry, economies of scale, and foreign government intervention. For example, legal barriers to entry or geographic isolation can cause imperfect competition
in some rural areas. If the lack of competition
forces some rural residents to pay excessively high
interest on loans, Government lending programs
aiming to increase the availability of credit and
lower the borrowing cost for those rural residents
may improve economic efficiency.
Changing Financial Markets
Financial markets have undergone many changes in
recent years. The most fundamental developments are
financial services deregulation and technological advances, which have promoted competition and economic
efficiency. Deregulation and technological advances
have led to many important developments. Deregulation has promoted consolidation by removing legal barriers to business combinations. By increasing the availability of information and lowering transaction costs,
technological advances have significantly contributed to
enhancing liquidity, refining risk management tools,
and spurring globalization. The current economic downturn, however, can temporarily interrupt these trends.
Financial services deregulation has promoted
competition by removing geographic and industry barriers. Active deregulation at the state level substantially removed restrictions on interstate banking and
intrastate branching in the 1980s and early 1990s. At
the Federal level, the full implementation of the RiegleNeal Interstate Banking and Branching Act in 1997
essentially removed geographic barriers. The Financial
Services Modernization Act of 1999 has repealed the
provisions of the Glass-Steagall Act and the Bank Holding Company Act that restricted the affiliation between
banks, securities firms, and insurance companies. The
Act allows financial holding companies to engage in
various financial activities, including traditional banking, securities underwriting, insurance underwriting,
asset securitization, and financial advising. As a result,
competition has become nationwide and across all financial products.
Advances in communication and information
processing technology have made the evaluation of
borrowers’ creditworthiness more accurate and lowered
the cost of financial transactions. Lenders now have
easy access to large databases, powerful computers, and
sophisticated analytical models. Thus, many lenders use

9. CREDIT AND INSURANCE

credit scoring models that evaluate creditworthiness
based on various borrower characteristics derived from
extensive credit bureau data. As a result, lending decisions have become more accurate and objective. Powerful computing and communication devices have also
lowered the cost of financial transactions by producing
new transaction methods such as electronic fund transfers, Internet banking, and Internet brokerage. The development of reliable screening methods and efficient
transaction methods have resulted in intense competition for creditworthy borrowers and narrowed lending
margins. Financial institutions are more willing to compete for customers with diverse characteristics, customers in distant areas, and small profit opportunities.
A notable example of increased competition is the credit
card business, where offering lower rates to lower-risk
customers has become much more common in recent
years.
Consolidation among financial institutions, especially banks, has been very active due to deregulation
and increased competition. Because of active consolidation, the number of banks has sharply decreased, and
the concentration of assets has increased. At the end
of calendar 2000, there were about 8,300 commercial
banks, which represented a decrease by over 4,000 or
33 percent from the end of calendar 1990. The top
10 banks controlled 37 percent of banking assets at
the end of calendar 2000, compared with 21 percent
at the end of calendar 1990. Consolidation across traditional industry boundaries has produced financial holding companies that control multiple types of financial
institutions. The leading example is Citigroup encompassing the commercial banking (Citibank), insurance
(Travelers), and securities (Salomon Smith Barney)
businesses.
Direct capital market access by borrowers has become more common. Advances in communication and
information processing technology enabled many companies (less-established medium-sized companies, as
well as large well-known ones) to validate their financial information at low costs and to borrow directly
in capital markets, instead of relying on banks. In particular, commercial paper (short-term financing instruments issued by corporations) has been very popular.
In the 1990s, growth of commercial paper substantially
outpaced growth of bank business loans. The current
economic slowdown, however, has had a much larger
negative effect on growth of commercial paper than on
growth of bank business loans.
Nonbank financial institutions, such as finance
companies and venture capital firms, increased their
market share, partly thanks to advanced communications and information processing technology that helped
to level the playing field. Over the last decade, both
consumer loans and business loans have been growing
at finance companies faster than at commercial banks.
The growth of venture capital firms was rather phenomenal. Between calendar 1995 and calendar 2000,
their new investments, which were mostly in small
firms’ equity, increased more than 17-fold (from $6 bil-

179
lion to $104 billion). Due to the economic downturn
and the slumping stock market, venture capital investments in calendar 2001 decreased to less than half
of the calendar 2000 level, but were still several times
as much as those in the mid-1990s.
Internet-based financial intermediaries provide
financial services more cheaply and widely. The Internet lowers the cost of financial transactions and reduces
the importance of physical location. Internet brokers
slashed the commission on stock trading. Internet-only
banks, which started appearing recently, bid up deposit
interest rates. Furthermore, their services are nationwide. The Electronic Signatures in Global and National
Commerce Act of 2000, which eliminates legal barriers
to the use of electronic technology to sign contracts,
should accelerate the growth of transactions over the
Internet.
Securitization (pooling a certain type of asset and
selling shares of the asset pool to investors) is a financial instrument produced by technological advances. Increased transparency of asset quality created demand
for securitized assets. Securitization has enhanced liquidity in financial markets by enabling lenders to
raise funds without borrowing or issuing equity. It also
helps financial institutions to reduce risk exposure to
a particular line of business. Commonly securitized assets include credit card loans, automobile loans, and
residential mortgages, whose quality can be more objectively analyzed. In recent years, financial institutions
began securitizing to a very limited extent many other
assets such as commercial mortgages and small business loans, the riskiness of which is more difficult to
evaluate.
Financial derivatives, such as options, swaps, and
futures, have improved investors’ ability to manage risk
(either increase or decrease risk exposure). Financial
institutions and some other types of companies are increasingly using these relatively new instruments to
manage various types of risk such as interest rate risk,
credit risk, price risk, and even catastrophe-related
risk. The interest rate swap, for example, is an effective
tool to reduce a firm’s exposure to interest rate movements. However, a firm can also use an interest rate
swap to take interest risk. Interest rate swaps are widely used now. After the September 11 attacks, catastrophe bonds drew some attention as a potential means
to manage a large risk. This derivative offers yields
higher than market interest rates. If a specified catastrophe occurs, however, the bondholders lose a part
or all of the principal, depending on the size of the
damage. In this contract, the higher yield and the loss
of principal respectively are equivalent to the insurance
premium and the insurance payout. In this way, the
potential large loss can be spread among a large number of investors, instead of a few insurance companies.
The size of the catastrophe bond market, however, is
still very small.
Globalization has been accelerating as a result of
the reduced importance of geographic proximity and
knowledge of local markets. Both commercial and in-

180

ANALYTICAL PERSPECTIVES

vestment banking institutions headquartered in Europe
and Japan are actively competing in the U.S. market,
and many U.S. financial institutions have branches
worldwide.
The current economic downturn has increased
loan delinquency rates and bankruptcies. The delinquency rate of business loans at banks averaged 2.9
percent during the first three quarters of calendar 2001,
compared with 2.2 percent in calendar 2000. The increases in delinquency rates were modest for consumer
loans (from 3.6 to 3.7 percent) and real estate loans
(from 1.9 to 2.1 percent). Between 2000 and 2001, however, personal bankruptcy filings increased 14.1 percent, which was much faster than the 6.6 percent increase in business bankruptcy filings. Jitters about
credit quality reduced the supply of business credit in
the private market, especially from nonbank sources
such as commercial paper. The stock market bust also
increased the cost of equity financing, especially for
start-ups that relied on venture capital. For households,
credit conditions remained relatively easy, partly
thanks to the continued strength of the housing market.
Implications for Federal Programs
In general, financial evolution has increased the private market’s capacity to serve the populations traditionally targeted by Federal programs and hence weakened the role of Federal credit and insurance programs.
Thus, it may be desirable to focus on narrower target
populations that still have difficulty in obtaining credit
from private lenders and on more specific objectives
that have been less affected by financial evolution.
Information about borrowers is more widely available and easier to process, thanks to technological advances. Credit scoring models, for example, enable lenders to screen many borrowers at low cost and to make
more accurate lending decisions. As a result, creditworthy borrowers are less likely to be turned down,
while borrowers that are not creditworthy are less likely to be approved for credit. The Federal role of improving credit allocation, therefore, is generally not as
strong as before. The benefit from financial evolution,
however, can be uneven across groups and over time.
Large financial institutions with global operations,
which are products of consolidation, may want to focus
more on large customers and business lines that utilize
economies of scale and scope more fully. Thus, some
small borrowers, who used to rely heavily on the private information of small institutions, can be underII.

served. In an economic downturn, lenders can be overly
cautious, leaving out some creditworthy borrowers. The
Federal Government may need to better target those
underserved groups, while reducing general involvement.
Externalities have not been significantly affected by
financial evolution. The private market fundamentally
relies on decisions at the individual level. Thus, it is
inherently difficult for the private market to correct
problems related to externalities.
Resource constraints have been alleviated.
Securitization and financial derivatives facilitate fund
raising and risk sharing. By securitizing loans and writing derivatives contracts, a lender can make a large
amount of risky loans, while limiting its risk exposure.
An insurer can distribute the risk of a natural or manmade catastrophe among a large number of investors
through catastrophe-related derivatives, although the
extent of risk sharing in this way is limited due to
the small size of the catastrophe bond market.
Imperfect competition is much less likely in general. Developments that contributed to increasing competition are financial deregulation, direct capital market access by borrowers, stronger presence of nonbank
financial institutions, emergence of Internet-based financial institutions, and globalization. Consolidation
has a potential negative effect on competition, especially in markets that were traditionally served by
small institutions. Given that the Nation still has many
banks and other financial institutions, the negative effect, if any, should be insignificant overall. It is possible, however, that some communities in remote rural
areas and inner city areas have been adversely affected
by consolidation.
Uncertainties about the Federal Government’s liability have increased in some areas. Consolidation has
increased bank size, and deregulation has allowed
banks to engage in many risky activities. Thus, the
loss to the deposit insurance funds can turn out to
be unusually large in some bad years. The potential
loss needs to be limited by large insurance reserves
and effective regulation. The large size of some GSEs
is also a potential problem. Financial trouble of a large
GSE could cause strong repercussions in financial markets, affecting federally insured entities and economic
activity. The current economic downturn also makes
it more difficult to estimate the costs of credit and
insurance programs because they can change abruptly.

A CROSS-CUTTING ASSESSMENT

To systematically assess Federal programs, policymakers and program managers need to consider the
following questions. (1) Are the programs’ objectives
still worthwhile? (2) Is the program economically justified? (3) Is the credit or insurance program the best
way to achieve the goals? (4) Is the program operating
efficiently and effectively? If the answer is ‘‘No’’ to any
of the first three questions, the program should be

eliminated or phased out. For programs that pass the
three tests, the focus should be on improving efficiency
and effectiveness.

9. CREDIT AND INSURANCE

Objectives
The first step in reassessing Federal credit and insurance programs is to identify clearly the objective of
each program, such as an increase in homeownership,
an increase in college graduates, an increase in jobs,
or an increase in exports. The objective must be worthwhile to justify a program. For some programs, the
objective might be unclear or of low importance. In
some other cases, an initially worthwhile objective
might have become obsolete. For example, the main
objective of the Rural Telephone Bank is to increase
telephone service in rural areas. This was a worthwhile
objective when many rural residents had limited or
costly access to telephone service. In the current environment with ample supply of telephone lines and intense competition among telephone companies, however, the objective may be obsolete.
Economic Justifications
For a credit or insurance program to be economically
justified, the program’s benefits must exceed its costs.
The benefits are the net effects of the program on intended outcomes compared with what would have occurred in the absence of the program. They exclude,
for example, gains that would have been obtained with
private credit in the absence of the program. Financial
evolution may have significantly affected the net benefit
from some programs. Suppose, for example, that financial evolution made information about borrowers transparent in some sectors where information opaqueness
had been a major problem. Then the net benefit would
be substantially smaller for the Federal programs that
were mainly intended to solve the information problem
in those sectors.
Many Federal credit and insurance programs involve
subsidy costs, and all of them incur administrative
costs. A subsidy cost occurs when the beneficiaries of
a program do not pay enough to cover the cost to the
Federal Government (e.g., they pay below-cost interest
rates and below-cost fees). The administrative costs include the costs of loan origination, direct loan servicing,
and guaranteed loan monitoring. The net benefit of a
program can be smaller than the combined cost of subsidy and administration either because it is inherently
costly to pursue the program’s goal or because the program is inefficiently managed (failure to maximize the
benefit and minimize the cost). The program should
be discontinued in the first case and restructured in
the second case.
Alternatives
Even a program that is economically justified should
be discontinued if there is a better way to achieve the
same goals. The Federal Government has other means
to achieve social and economic goals, such as providing
direct subsidies, offering tax benefits, and encouraging
private institutions to provide the intended services.
In general, direct subsidies are more efficient than
credit programs for the purpose of fulfilling social objectives such as helping low-income people, as opposed

181
to economic objectives such as improving credit allocation. Direct subsidies are less likely to interfere with
the efficient allocation of resources. Suppose that the
Government makes a subsidized loan to be used for
a specific project. Then the borrower will undertake
the project if its return is greater than the subsidized
rate. Thus, the subsidized loan can induce the borrower
to undertake a normally unprofitable project and hence
result in a social loss. On the other hand, a direct
subsidy is a simple income transfer, which is less likely
to cause a social loss.
To a certain extent, the Federal Government can also
correct market failures by helping the private market
to improve efficiency, instead of directly offering credit
or insurance. For example, policies encouraging the
standardization of information (e.g., standardization of
loan origination documents) may improve the private
lenders’ ability to serve those sectors where information
is opaque. Standardization helps to reduce opaqueness
by facilitating information processing. With reduced
opaqueness, loan sales should be easier, and the secondary market should develop more quickly. Then the
lending market would be more liquid and competitive.
A more specific example is the development of floodplain maps by the National Flood Insurance Program.
Before the development of the maps, private insurance
companies had little information on flood risks by geographic area. The lack of information was a main reason why private companies were unwilling to insure
against flood risk.
Improving Efficiency
Some programs may be well-justified based on the
three criteria above. However, few programs may be
perfectly designed or managed. It is almost impossible
to take all relevant factors into consideration at the
beginning. In addition, financial evolution can lower
the efficiency of initially well-designed and well managed programs. Thus, improving efficiency is an everlasting concern. Although the ways to improve efficiency vary across programs, there are some general
categories and principles that apply to most programs.
Pricing (setting appropriate lending terms or insurance premiums) is a critical part of credit and insurance programs. If program managers fail to accurately
estimate the default and prepayment probabilities for
a credit program and the loss probability for an insurance program, the program may be mispriced, and the
actual subsidy may substantially deviate from the intended subsidy. To improve the estimation accuracy,
using advanced analytical tools is important, especially
for some programs, for which pricing involves many
complications. An inappropriate intended subsidy rate
can also impair program efficiency. If a program’s subsidy is too small, the intended population may be discouraged from using the program. On the other hand,
an excessive subsidy may attract unintended customers.
Some programs are inherently difficult to price. To
price deposit insurance, for example, the Federal Deposit Insurance Corporation (FDIC) needs to estimate

182
bank failure probabilities, which are highly changeable.
An unexpected event can cause many failures, and the
banking business changes over time, introducing new
risks. FDIC recently made a constructive proposal to
improve deposit insurance pricing. Agencies dealing
with complicated pricing need to continuously endeavor
to refine pricing. In many cases, utilizing both historical
experience and sophisticated analytical tools may be
necessary. Private sector participation may also help
the pricing of complicated programs. Federal agencies
can make risk-sharing arrangements with private firms
that may have better pricing expertise and derive information from the private firms’ pricing.
The subsidy rate and the manner in which subsidies
are provided can also affect program efficiency. The
Farm Service Agency (FSA) offers agricultural loans
at Treasury rates to borrowers who have been denied
credit by private lenders. Since Treasury rates are
lower than market rates for creditworthy borrowers,
this pricing strategy can attract borrowers who can obtain credit elsewhere. It is possible that some creditworthy borrowers are denied credit by chance or by
misrepresentation. One solution to this problem is to
make loans at the market rate for average borrowers,
which would still subsidize the intended population
with low credit ratings. When further subsidies to the
disadvantaged are desirable, the Government may supplement the loans with direct subsidies.
Another pricing issue arises when the Government
relies on private intermediaries. The student loan guarantee program sets the interest rate that participating
lenders receive, which differs from the rate that students pay. While an unattractively low lender rate set
by the Government would reduce participation, an excessively high rate would unnecessarily increase the
cost of the program. A similar problem exists for the
crop insurance program. Private insurance companies
sell and service crop insurance policies, and the Federal
Government reimburses the private companies for the
administrative expenses and reinsures them for excess
insurance losses. Excessive profits of private companies
are also possible in this case. One way to deal with
this problem is to carefully examine the profit of participating intermediaries. An alternative is to set the
price through competitive bidding.
Targeting the right population is also an important element of program efficiency. The net benefit will
increase if program managers more successfully identify
the populations that would benefit more from credit
and insurance programs and reach out to them. Right
populations include borrowers who have worthwhile
projects but have difficulty in obtaining private credit
(e.g., beginning farmers, new businesses, new exporters), populations underserved by the private market
(e.g., low-income, minority), underserved neighborhoods
(e.g., rural, inner city), and legislatively targeted populations (e.g., students, veterans). In addition to making
credit available, program managers need to actively inform potential borrowers of the credit availability and
provide high-quality customer services, so that igno-

ANALYTICAL PERSPECTIVES

rance or inconvenience does not deter the targeted populations from accessing the program. Federal credit programs can also play a more useful role when there
is temporary inefficiency in the private market. The
financial market can occasionally face a liquidity crisis
or become overly pessimistic (e.g., at the time of the
Asian financial crisis and the near collapse of Long
Term Capital Management, a hedge fund). Economic
downturns can also reduce the credit available from
private sources, as evidenced by declines in commercial
paper and venture capital investment in 2001. On those
occasions, Federal agencies can promote the extension
of credit to creditworthy borrowers. While outreaching,
program managers should avoid overreaching, which
would waste taxpayers’ money.
While targeting may not be a problem for some welldefined programs, such as deposit insurance and student loan programs, it can be a major concern for many
programs that serve broader purposes, such as housing,
business, and international programs. Given that private lenders have been reaching out to more traditionally underserved homebuyers, for example, there are
ever increasing needs for Federal housing agencies to
improve their focus on the populations that may still
be underserved by the private market, such as minorities and inner city residents. In the agricultural sector,
FSA provides loan guarantees to many borrowers who
have access to private credit. To improve program efficiency, FSA needs to focus on borrowers who would
benefit most from the government program (for example, helping more small, beginning farmers and fewer
large, established farmers). The Small Business Administration (SBA) faces a similar problem. Given that the
definition of small business is not really tight, access
to private credit may differ widely across small businesses. It is an ongoing challenge for SBA to focus
more narrowly on start-ups and very small businesses,
which may have more difficulty in obtaining credit
without Government assistance.
Even when the target population is fairly well defined, a program can extend its role beyond the original
mission. The housing program of the Department of
Veterans Affairs (VA), of which the main purpose is
to help veterans, offers direct loans to the purchasers
of foreclosed VA homes, who are not veterans. The
loans do not necessarily increase the cost to the government if the favorable lending terms positively influence
sale prices. Nevertheless, the loans to the general public can be considered as overreaching. The program also
allows veterans to obtain the subsidized loans more
than once. Provided that the primary goal of the program is to help disadvantaged veterans right out of
the military, repeated offers of subsidized loans may
be unnecessary in many cases. Rural Utilities Service
(RUS) offers credit to utility providers serving rural
areas. Once the eligibility is determined, however, requalification is not required for new loans. This lax
rule enables some borrowers, where rural areas have
become urban after the first loan, to obtain new loans
to support both rural and urban areas.

9. CREDIT AND INSURANCE

Targeting too narrowly can also be a problem. Export
credit provided by the Export-Import Bank is highly
concentrated to a few large exporters. Overseas Private
Investment Corporation (OPIC) has been primarily assisting large U.S. companies investing abroad. In these
cases, reaching out to smaller exporters and investors
might improve program efficiency.
Risk management needs to be effective to limit the
cost of credit and insurance programs. Careful screening of borrowers would reduce the default risk. Although the goal of most credit programs is not to lend
to the most creditworthy borrowers, it is important to
identify relatively more creditworthy borrowers even
among those who might be denied credit by private
lenders. Other key elements of risk management include monitoring existing borrowers and collecting defaulted loans. One way to improve screening, monitoring, and collecting is to use advanced analytical tools
such as credit scoring and to maintain useful data
bases. In some cases, the private sector may perform
those tasks more efficiently. Then delegation would be
an effective strategy. For example, if banks are better
at screening some opaque borrowers because of their
extensive experience with those borrowers, Federal
agencies may delegate the screening of those borrowers
to banks with appropriate risk-sharing arrangements.
Technological advances have significantly improved
the screening of borrowers, especially in the housing
market, where standardizing information is relatively
easy. Private lenders process loans efficiently using
automated and sophisticated tools. Federal agencies
targeting the populations that are largely served by
the private sector need to be alert to catch up with
rapid technological advances. Falling behind, they could
be left with riskier borrowers. Analytical models also
play an important role in monitoring borrowers and
insurance policyholders. Pension Benefit Guarantee
Corporation (PBGC) has an Early Warning Program
designed to identify weak industries and companies.
The program, which facilitates early intervention and
negotiations, has been fairly successful in reducing insurance losses.
Since standardizing information is still difficult for
small business, banks with extensive business relationships may have advantages in screening borrowers. The
Small Business Administatin (SBA), which guarantees
small business loans, delegates credit evaluation with
some risk-sharing arrangements. SBA has been
strengthening the delegation through its Preferred
Lender Program, which has shown some success in reducing default rates. However, since designing optimal
risk-sharing arrangements is a challenging task, SBA
and other Federal agencies delegating credit evaluation
to private lenders should keep trying to develop finer
risk-sharing arrangements.
Delegation of loan servicing is generally desirable,
but it should be accompanied by close monitoring of
contractors. VA lets private servicers track the performance of VA loans. VA, however, is not notified of delinquencies until loans are 60 to 90 days overdue. Closer

183
monitoring might help to reduce the default rate of
VA loans. The performance of private contractors may
also be improved through performance-based contracting. The Department of Education (ED) relies on
private contractors for collecting defaulted student
loans. ED lets multiple debt collectors compete for the
loan volume by assigning more loans to the best performers. This performance-based contracting has helped
to increase the collection of defaulted loans.
Cost control is a concern for all types of organizations. For Federal credit and insurance programs, key
elements include delivery and servicing costs, in addition to the general administration cost. There are many
ways for Federal agencies to save costs. They may
streamline the delivery system, computerize loan servicing, and eliminate redundant servicing facilities. In
cases where the private sector is more efficient in some
specific functions such as loan servicing, it may be best
to contract out those functions. When several Federal
agencies serve similar purposes, inter-agency cooperation can result in a substantial cost saving.
The student loan guarantee program involves multiple layers of private and public institutions. There
may be an opportunity to streamline the delivery system and save on administrative cost. SBA operates multiple loan servicing centers throughout the Nation.
Given that advances in communication technology have
reduced the importance of physical presence for loan
servicing, consolidating some of those facilities might
reduce costs without sacrificing customer service.
ED contracts out the servicing of direct student loans.
Since many private institutions are more experienced
with loan servicing than the Government, contracting
out can be more cost-effective in many cases. To realized the potential cost savings, however, Federal agencies need to use well-designed competitive bidding and
incentive arrangements, as well as to monitor the quality of service. Without these appropriate steps, contracting out could represent more of a private opportunity for a windfall gain than of the Government’s
opportunity for a cost saving. The Federal Housing Administration and SBA have been selling loans to private
financial institutions. Provided that private institutions
are more efficient in loan servicing, loan sales should
help to save servicing and administrative costs. Welldesigned competitive bidding is important in this case,
as well.
There are several Federal agencies that are involved
in home-purchase financing and several agencies that
provide export-related credit. In these cases, substantial
cost saving can be achieved through sharing data bases,
exchanging expertise, and consolidating redundant operations. Housing agencies have been sharing data, but
to a limited extent. International credit agencies use
a common risk assessment system. There may remain
many cost-saving opportunities that can be realized
through fuller cooperation.
Initiative plays an important role in a rapidly
changing environment. Information technology and fi-

184
nancial markets have been changing rapidly. To achieve
the maximum efficiency, program managers need to
closely watch and quickly adapt their programs to new
developments. Tardy responses to changes in information technology may mean missed opportunities for improving risk management and reducing costs. Financial
market developments also have important implications.
For example, many loans guaranteed by the Government are securitized. Securitization may reduce the
lenders’ incentives to screen and monitor borrowers if
they believe that guaranteeing agencies do not properly
track the performance of securitized loans. To prevent
this adverse effect, the Government needs well-organized databases and modern monitoring systems. Private lenders are more willing to serve many customers
to whom they did not want to lend in the past. Thus,
some Federal credit programs may need to focus more
narrowly on customers who are still underserved by
private lenders. Without agencies’ initiative, needed adjustments might be substantially delayed.
Federal agencies have been active in initiating automation and Internet-based services. PBGC has a pilot
project that enables participants in certain PBGCtrusteed plans to calculate their approximate benefits
online. VA recently developed web-based application
that allows lenders to obtain appraiser assignments and
loan numbers for VA loan applications. ED has undertaken an automation and modernization initiative to
streamline the management of student financial assistance programs. Rural Utilities Service has made many
forms available for download at its website.
Many agencies have proposed to develop analytical
models to improve risk management. SBA has been
developing a loan monitoring system and an advanced
subsidy-estimation model. Rural Housing Service have
been working on models to evaluate the creditworthiness of borrowers. However, the progress has been slow
in many cases.
There have also been proposals for regulatory
changes. FDIC recently made reform proposals ranging
from merging bank and thrift insurance funds to refining risk-based premiums. FHA recently proposed a rule
that would help to reduce fraudulent practices in the
housing market. In general, however, credit and insurance agencies have not been very active in proposing
regulatory changes. Given that individual agencies are
on the frontiers of detecting changes in market conditions, they may need to take a more active role in
bringing about regulatory changes that would improve
the effectiveness and efficiency of their programs.
Federal Loan Asset Sales: A Current Issue in Improving Efficiency
Federal loan asset sales provide an opportunity for
agencies to achieve many of the efficiency gains already
discussed. For programs where loan asset sales are appropriate, sales can free up existing agency resources
to better serve their target population, lower the risk
exposure of the Federal government, and create better
overall management of Federal loan assets. In addition,

ANALYTICAL PERSPECTIVES

while outsourcing specific functions, such as loan servicing, to the private sector has shown cost savings to
the Government, outsourcing requires careful monitoring of the contractor. By selling the asset outright
to the private sector, Federal agencies can further reduce administrative costs.
At the end of 2000, the Federal Government held
loan assets valued at $241 billion. Of the $241 billion,
$208 billion were direct loans, and $33 billion were
guaranteed loans acquired by the Federal Government
after default. Both types of loans are eligible to be
sold. Sale of Federal loan assets can provide several
benefits to the Federal Government: revenues from
sales, administrative cost savings, and management improvements. In a time of tight budgetary resources, it
makes good sense to free up agency resources for redirection to core Governmental functions and outsource
activities that are more efficiently done by the private
sector. Agencies can use the freed-up financial and
human resources to better target new lending to the
right population, better manage the remaining portfolio,
and improve technological areas where they are lagging, such as loan servicing and credit screening.
The Debt Collection Improvement Act of 1996 (DCIA),
which authorizes agencies to sell debt that is over 90
days delinquent, grew out of an increased recognition
of the Government’s inefficiency at managing poorly
performing assets. For example, some agencies did not
have a policy in place to take action when borrowers
were delinquent or in default. The lack of an adequate
policy resulted in unnecessarily large losses to the Government. In implementing the DCIA, OMB Circular
A–129 imposes a more stringent rule requiring agencies
to sell loans that are over one year delinquent and
loans for which collection action has been terminated.
Circular A–129 also recommends that agencies develop
plans for selling performing loans, thereby using asset
sales as a portfolio management tool.
To effectively conduct loan sales, agencies need to
establish policies and procedures for tracking both performing and non-performing loans. These efforts will
also help to improve overall portfolio management, resulting in reduced default rates and better cost estimates for future loans. Agencies may also acquire
knowledge that helps to decide outsourcing of some
functions such as loan servicing and liquidation.
The bulk of Federal loan assets are held by five Federal credit agencies: Department of Veterans Affairs,
Department of Agriculture, Department of Education,
the Federal Housing Administration (FHA), and the
Small Business Administration (SBA). To date, two
agencies, FHA and SBA, have conducted loan asset
sales, selling non-performing loans, which satisfies the
DCIA provisions of selling delinquent loans, and selling
performing loans as well. Successful sales to date by
these two agencies have shown that loan assets can
be priced advantageously to both the Government and
the private sector due to the private sector’s expertise
and scale economies in loan servicing. Both agencies
are currently planning future sales. The sales to date

185

9. CREDIT AND INSURANCE

have generated revenue for the Government, while reducing the costs of maintaining and liquidating those
assets. Other benefits of asset sales include the transfer
of resources from certain credit program functions that
III.

are not inherently Governmental to core Governmental
functions that are essential in carrying out the mission
and overall improvements in asset management.

CREDIT IN FOUR SECTORS

Housing Credit Programs and GSEs
The Federal Government makes direct loans, provides
loan guarantees, and enhances liquidity in the housing
market to promote homeownership among low- and
moderate-income people and to help finance rental
housing for low-income people. While direct loans are
largely limited to low-income borrowers, loan guarantees are offered to a much larger segment of the population, including moderate-income borrowers. Increased
liquidity achieved through GSEs benefits virtually all
borrowers in the housing market, although it helps low
and moderate-income borrowers more.
The main government agencies and GSEs involved
in housing finance are the Department of Housing and
Urban Development (HUD), the Department of Veterans Affairs (VA), the Department of Agriculture
(USDA), Fannie Mae, Freddie Mac, and the Federal
Home Loan Bank System. In 2001, HUD, VA, and
USDA supported $219 billion of direct loans and loan
guarantees, contributing to a record high homeownership rate of 68.1 percent. Roughly one out of six singlefamily mortgages originated in the United States receives assistance from one of these programs.
Federal Housing Administration
HUD’s Federal Housing Administration (FHA) operates several insurance funds, the largest of which is
the Mutual Mortgage Insurance Fund. FHA mortgage
insurance is directed to expanding access to homeownership for people who lack the financial resources
or credit history to qualify for a conventional home
mortgage. In 2001, FHA insured $107 billion in mortgages for almost 1 million households, 10 percent more
households than in 2000. The dollar volume of mortgages exceeded 2000 by 24 percent, partially driven
by the rapid increase in house prices and low interest
rates.
FHA has contributed significantly to the recent homeownership gains, but its target population of first-time
home buyers is most at risk of surrendering these
gains. After increasing significantly since 1994, the
share of FHA’s home purchase mortgages going to firsttime home buyers and minority households dropped
slightly in 2001. FHA helped its borrowers retain their
homes by increasing use of loss mitigation tools (such
as lender forbearance, loan modification, and partial
claims) by 62 percent over the previous year. The Budget will further protect home buyers from losing their
homes by expanding HUD homeownership counseling
to nearly twice as many families. HUD delivers both
pre- and post-purchase counseling services through a
network of counseling agencies.

Congress enacted a 2002 Budget proposal to allow
FHA to insure a financial product that has gained popularity in the conventional market—hybrid adjustablerate mortgages. Congress also clarified HUD’s legal authority to operate FHA Credit Watch—a lender monitoring program that rates lenders by the performance
of the loans they underwrite and allows FHA to sever
relationships with those showing poor performance.
Credit Watch is critical to protect the FHA Mutual
Mortgage Insurance Fund from unexpected losses due
to mismanagement and fraud.
FHA combats fraud on many fronts, including predatory lending. The President’s Management Agenda sets
out several critical tasks for FHA to improve its risk
management. FHA issued a proposed rule in 2001 that
would prevent the predatory practice of property flipping, in which a lender and an appraiser conspire to
sell a home at a falsely inflated price, thereby victimizing the borrower and exposing FHA to excessive
losses. The Department is considering other regulatory
changes to help prevent predatory lending.
FHA Neighborhood Watch helps home buyers help
themselves by providing an internet-accessible lender
monitoring system. The system tracks each lender’s defaults, by neighborhood, enabling a mortgage shopper
to identify lenders with good records of mortgage performance in the shopper’s local area. Lenders with high
rates of defaulted loans are flagged as potential problems. The system also helps the industry self-police;
other financial institutions are unlikely to purchase
FHA loans from a lender identified by Neighborhood
Watch as high risk.
VA Housing Program
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 2001, VA provided $31 billion
in guarantees to assist 252,700 borrowers. Both the
volume of guarantees and the number of borrowers increased substantially from 2000 as lower interest rates
increased loan originations and refinancings in the
housing market.
Since the main purpose of this program is to help
veterans, lending terms are more favorable than market
rates. In particular, VA guarantees zero down payment
loans. As a result, the default rate is relatively high.
The subsidy rate, however, declined slightly in 2001,
thanks to efforts to reduce foreclosure rates and the
strong housing market.
In order to help veterans retain their homes and
avoid the expense and damage to their credit resulting

186
from foreclosure, VA plans aggressive intervention to
reduce the likelihood of foreclosures when loans are
referred to VA after missing three payments. VA was
successful in 40 percent of their 2001 interventions,
and its goal is to maintain the 40 percent level in
2003. Future military base closures, however, may negatively affect the default rate in the VA guaranteed
housing program. Guaranteed loans issued to active
duty military and military reservists are vulnerable to
the impact of base closures on the neighboring community. VA is continuing its efforts to reduce administrative costs through restructuring and consolidations.
Rural Housing Service
USDA’s Rural Housing Service (RHS) offers direct
and guaranteed loans and grants to help very low- to
moderate-income rural residents buy and maintain adequate, affordable housing. The single family guaranteed
loan program guarantees up to 90 percent of a private
loan for low to moderate-income rural residents. The
program’s emphasis is on reducing the number of rural
residents living in substandard housing. In 2001, $2.4
billion of guarantees went to 31,000 households, of
which 30 percent went to low-income borrowers (with
income 80 percent or less than median area income).
For 2001, Congress statutorily increased the premium
charged on the RHS single-family guarantees from 1
to 2 percent, which allowed RHS to provide more guarantees at less cost to the taxpayers.
In the single family housing guaranteed loan program, lender monitoring and external audits have
helped to identify program weaknesses, train servicers,
and identify troubled lenders. RHS’s guaranteed loan
program is also moving toward automated underwriting. In 2001, RHS continued to enhance an Internet-based system that will, with future planned improvements, provide 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 RHS, the lenders, and customers. RHS
continues to operate under the ‘‘best practice’’ for asset
disposition for its guaranteed loan program. For single
family guarantees, the lender is paid the loss claim,
including costs incurred for up to three 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 to dispose of the property.
RHS programs differ from other Federal housing loan
guarantee programs. RHS programs are means-tested
and more accessible to low-income, rural residents. In
addition, the RHS direct loan program offers deeper
assistance to very-low-income homeowners by reducing
the interest rate down to 1 percent for such borrowers.
The program helps the ‘‘on the cusp’’ borrower obtain
a mortgage, and requires graduation to private credit
as the borrower’s income increases over time. The interest rate depends on the borrower’s income. Each loan
is reviewed annually to determine the interest rate that

ANALYTICAL PERSPECTIVES

should be charged on the loan in that year based on
the borrower’s actual annual income.
The program cost is balanced between interest subsidy and defaults. For 2003, RHS expects to provide
$1 billion in loans with a subsidy cost of 19.37 percent.
Its most recent and ongoing servicing improvement effort has been the implementation of the Dedicated Loan
Origination Service System (DLOS), which centralized
the servicing and monitoring of the direct loan program.
DLOS, in conjunction with 2 major regulations implemented between 1996 and 1997, reduced RHS’s direct
loan subsidy rate by 40 percent. RHS has reduced default rates and losses. RHS also has less than 1,200
Real Estate Owned (REO) properties, which is less than
0.02 percent of the portfolio.
RHS also offers multifamily housing loans. Direct
loans are offered to private developers to construct and
rehabilitate multi-family rental housing for very-low to
low-income residents, elderly households, or handicapped individuals. These loans to developers are very
heavily subsidized; the interest rate is between 1 and
2 percent. The Farm Labor Housing direct loans, which
are similarly priced, help developers to provide rental
units for minority farm workers and their families. RHS
rental assistance grants supplement both of these loan
programs in the form of project based rents for very
low-income rural households (for renewals and new construction, the cost will be $712 million in 2003). RHS
also offers guaranteed multifamily housing loans. RHS
will address management issues in its multifamily
housing portfolio in 2003 by restricting the $60 million
loan level to repair and rehabilitation of it’s existing
portfolio (17,800 projects, 459,000 units). They will also
conduct a study on how to fund new construction in
a more cost efficient manner with the expectation that
new construction will be a priority for the funds in
future budgets. Farm labor housing will have a program level of $53 million and will provide for new construction.
Housing Finance Challenges and Opportunities
Private banks, thrifts, and mortgage bankers, which
originate the mortgages that FHA insures and VA and
RHS guarantee, may deal with all three programs, as
well as with the Government National Mortgage Association (Ginnie Mae, an agency of the Department of
Housing and Urban Development), which guarantees
timely payment on securities based on pools of these
mortgages. In addition, the same private firms originate
conventional mortgages, many of which are securitized
by Government-sponsored enterprises—Fannie Mae and
Freddie Mac.
Many of these firms already use or are moving toward electronic loan origination and automated underwriting. Behind such underwriting are data warehouses
that show default experience by type of loan, borrower
characteristics, home location, originator, and servicer.
Automated valuation models relate these factors to default cost, and provide comparative analysis of home
sales data to estimate property collateral values with-

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9. CREDIT AND INSURANCE

out relying on a human appraiser. After loan origination, software programs grade delinquent loans in
terms of their credit and collateral risk and allow
servicers to devote resources to the highest-risk loans.
These technological developments offer challenges
and opportunities to the Federal mortgage guarantors
and Ginnie Mae. Federal credit program managers are
challenged to make programs electronically accessible
to their clients and loan originators. They are challenged to assess and monitor their risks more closely
as private firms are reaching out to the better risks
among their potential clients. They also have an opportunity to provide better service at a lower cost, to target
their efforts to help borrowers retain their homes, and
to reach further to bring affordable housing and homeownership opportunities to those who are not currently
served.
Data Sharing. Federal credit program managers are
benefitting and would benefit more from additional
data-sharing capability across the Government, which
provides access to integrated information on program
designs, borrower characteristics, and lender and loan
performance.
Loan Origination. Electronic underwriting provides
convenient, faster service at a lower cost to both lenders
and borrowers. Currently, both FHA and VA permit
mortgage lenders to use approved automated underwriting systems, including Freddie Mac’s ‘‘Loan Prospector’’ and Fannie Mae’s ‘‘Desktop Underwriter,’’ to
originate these loans. FHA, however, will soon deploy
its ‘‘Total Scorecard.’’ By transitioning FHA’s third
party lenders to its own automated scorecard, FHA will
improve its program controls and credit management.
RHS is currently developing its own system and scorecard.
Performance Measurement. As in underwriting,
private firms are heavily involved in servicing Government-backed mortgages. Measurement of the private
sector’s servicing capacity is thus critical. The Government needs to improve its systems to measure this
performance. For example, monthly data would not only
give housing programs a better understanding of how
their guarantee portfolios behave, but also serve as an
early warning system and feedback mechanism. The
Government could adjust underwriting standards or
loan servicing requirements in quick response to changing market conditions.
Managing Risk. 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 to reflect risk accurately.
Federal loan guarantee programs are assessing the impact of private sector customization on their loan port-

folios, and adopting a similar pricing structure to avoid
riskier customer composition and larger losses. FHA
recently authorized annual premium cancellation at 78
percent loan-to-value ratio. Proceeding cautiously, FHA
will next explore varied pricing for its mortgage insurance based on risk factors such as impaired credit or
limited resources, for borrowers who currently do not
qualify for FHA insurance, to help achieve the President’s goal of increasing homeownership. More flexible
pricing would let FHA extend its reach and thereby
enable more borrowers to purchase a first home at a
reasonable mortgage cost.
Asset Disposition. Common wisdom in the mortgage
industry is to avoid foreclosure because that process
involves significant losses, including costs for maintenance and marketing. Managers of Federal guarantee
programs have found that the best practice is to allow
the more experienced private sector to manage delinquent loans and dispose of properties. By 2003, FHA
will move out of the property management business
for the majority of its defaulted loans by implementing
its statutory authority to accelerate the mortgage insurance claim process. The accelerated claim process will
enable FHA to sell defaulted notes to the private sector
for servicing and/or disposition, thereby reducing foreclosures and eliminating much of the acquisition of real
property and increasing net recoveries by FHA.
Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac were chartered by Congress to increase the liquidity of mortgages and to promote access to mortgage credit for households that historically have been underserved by private markets.
They carry out this mission by purchasing and/or guaranteeing residential mortgages. The guaranteed loans
are packaged for sale as mortgage-backed securities
(MBS), which are held by general investors, mortgage
lenders, and Fannie Mae and Freddie Mac themselves.
The two GSEs finance their acquisitions of loans and
MBS assets by issuing debt. In September 2001, Fannie
Mae and Freddie Mac had $2.6 trillion outstanding in
mortgages that they had purchased or guaranteed. Of
this, $1.2 trillion was held in the GSEs’ asset portfolios,
and $1.4 trillion served as collateral for outstanding
MBS not held in portfolio. Together, the two firms’ purchases of single-family mortgages averaged 63 percent
of all conventional conforming mortgages originated in
calendar years 1998–2000 measured by dollar value.
Fannie Mae and Freddie Mac have grown faster than
the mortgage market in recent years. From September
1997 to September 2001, their combined mortgage asset
portfolios increased 150 percent in dollar volume, and
their guarantees of MBS increased 40 percent. To fund
their rapidly growing asset portfolios, Fannie Mae and
Freddie Mac have increased their outstanding debt. The
GSEs’ combined debt outstanding rose from $518 billion
at September 1997 to $1.26 trillion at the end of September 2001, an annualized growth rate of nearly 25
percent a year.

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Increased guarantee volume and retained portfolios
imply increased credit and interest rate exposure. In
recent years, both Fannie Mae and Freddie Mac have
tried to limit their credit and interest rate risk using
various risk management techniques such as credit enhancements,
additional
pool-level
insurance
supplementing primary mortgage insurance, long-term
callable debt, interest rate swaps, and other hedging
transactions. These risk management tools, however,
do not eliminate all the risk associated with funding
long-term, mostly fixed-rate assets that have uncertain
payment streams. Furthermore, the hedging transactions transform credit or interest rate risk into
counterparty risk (the risk that the counterparty of a
hedging transaction fails to honor the contract). Thus,
the GSEs’ management of counterparty risk is of increasing importance.
The credit quality of mortgages owned or guaranteed
by Fannie Mae and Freddie Mac has benefited in recent
years from strong housing markets that have improved
collateral values. More typical growth in house prices
and a weaker economy might raise credit costs from
the very low levels of recent years. The credit risk
to the GSEs from new or outstanding loans is limited
by their required use of mortgage insurance and other
credit enhancements for loans with high loan-to-value
(LTV) ratios. Both GSEs are increasingly active purchasers of subprime loans, and mortgages with very
high LTV ratios, which now range up to 100 percent.
These loans tend to have more credit risk than the
GSEs’ traditional mortgage purchases.
The Federal Housing Enterprises Safety and Soundness Act of 1992 reformed Federal regulation of Fannie
Mae and Freddie Mac. The Act created the Office of
Federal Housing Enterprise Oversight (OFHEO) to conduct safety and soundness examinations and enforce
minimum leverage and risk-based capital requirements
on Fannie Mae and Freddie Mac. Examinations of the
GSEs and enforcement of leverage capital ratios have
proceeded since OFHEO’s inception. Risk-based capital
requirements were published in September 2001 and
become fully enforceable in September 2002.
Fannie Mae and Freddie Mac took steps in 2001 to
help the market identify any future change in their
riskiness. The GSEs have committed to issue subordinated debt on a regular basis. Following a three-year
phase-in period, subordinated debt will equal about 1.5
percent of their on-balance-sheet assets. Because holders of subordinated debt have a junior claim on the

ANALYTICAL PERSPECTIVES

assets of the GSEs, subordinated debt prices tend to
be more sensitive to marginal changes in risk. The price
of the GSEs’ subordinated debt, therefore, could provide
a market signal of an increase in their riskiness.
Because of the benefits derived from their unique
Federal charters, Fannie Mae and Freddie Mac have
lower costs of senior debt and obtain better pricing
on securities’ issuance. The Congressional Budget Office
(CBO) estimates that, in 2000, these implicit subsidies
combined with the GSEs’ tax and regulatory exemptions were worth $10.7 billion. According to the study
(‘‘Federal Subsidies and the Housing GSEs,’’ May 2001),
the GSEs passed along 64 percent of the $10.7 billion
in implicit subsidy and tax and regulatory benefits to
mortgage borrowers, while 36 percent accrued to the
benefit of the shareholders and other stakeholders of
Fannie Mae and Freddie Mac.
One of the GSEs’ public purposes is to promote access
to mortgage credit for low- and moderate-income families in underserved areas. Accordingly, the Secretary
of Housing and Urban Development (HUD) establishes
affordable housing goals for the GSEs. The goals effective for calendar years 2001–2003 require the following:
• 50 percent of the total number of dwelling units
financed by each GSE’s mortgage purchases are
affordable by low- and moderate-income families
(Low- and Moderate-Income Housing Goal);
• 31 percent of the total number of dwelling units
financed by each GSE’s mortgage purchases are
in central cities, rural areas, and other
metorpolitan areas with low and moderate income
and high concentrations of minority residents
(Geographically Targeted Goal); and
• 20 percent of the total number of dwelling units
financed by each GSE’s mortgage purchases are
special affordable housing for very-low-income
families and low-income families living in low-income areas (Special Affordable Goal).
Fannie Mae and Freddie Mac have met or exceeded
the affordable housing goals since they were established
in 1996. The GSEs’ achievements, however, do not surpass the level of affordable lending in the conventional
market. By the most recent estimate available, the conventional market’s loans to low- and moderate-income
families and families in underserved areas exceed the
purchases of such mortgages by Fannie Mae and
Freddie Mac. (See the table ‘‘Mortgages to Target Populations.’’)

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9. CREDIT AND INSURANCE

Mortgages to Target Populations
(Percent)
Low- and
ModerateIncome
Private market average* ....................................................................
Freddie Mac in 2000 ..........................................................................
Fannie Mae in 2000 ...........................................................................
HUD Goal for GSEs in 2000 .............................................................

56
50
49
42

Geographically
Targeted

Special Affordable Housing

33
29
31
24

28
21
19
14

Source: Department of Housing and Urban Development (HUD).
* Private market average 1995–98, the most recent market average available from HUD for the conventional conforming market. ‘‘HUD’s Regulation of Fannie Mae and Freddie Mac; Final Rule,’’ Federal Register, October 31, 2000,
page 65055.

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 advances
(secured loans) to its members. Member institutions primarily secure advances with residential mortgages and
other housing-related assets.
The Gramm-Leach-Bliley (GLB) Act of 1999 repealed
the requirement that federally chartered thrifts be
members of the FHLBS. Membership is open to federally chartered and state-chartered thrifts, commercial
banks, credit unions, and insurance companies on a
voluntary basis. As of September 30, 2001, 7,897 financial institutions were FHLBS members, an increase of
177 over September 2000. About 73 percent of members
are commercial banks, 19 percent are thrifts, and the
remaining 8 percent are credit unions and insurance
companies. However, 53.2 percent of outstanding
FHLBS advances were held by thrifts as of September
30, 2001.
The FHLBS reported net income of $2.1 billion for
the year ending September 30, 2001, down from $2.2
billion in the previous 12 months. System capital rose
from $30.6 billion to $33.1 billion, while the ratio of
capital to assets remained unchanged at 4.8 percent.
Average return on equity was about 6.6 percent. Outstanding advances reached $466.8 billion in September
2001, an 8.6 percent increase over the $429.8 billion
outstanding a year earlier. As of September 30, 2001,
about 64 percent of advances had a remaining maturity
of greater than one year—up from 52 percent one year
earlier.
The GLB Act requires the System to adopt a riskbased capital structure. On October 26, 2001, the Federal Housing Finance Board (Finance Board) approved
a revised final capital standards rule. The rule covers
System governance, stock issuance, and risk-based and
leverage capital requirements. These new capital standards, when fully implemented, will replace the current
‘‘subscription’’ capital structure for the Federal Home
Loan Banks (FHLBanks) with one that includes both
risk-based and minimum leverage requirements. Each
Bank will also be required to adopt and implement

a capital plan consistent with provisions of the GLB
Act and Finance Board regulations.
The GLB Act changed the FHLBanks’ annual payment towards the interest payments on bonds issued
by the Resolution Funding Corporation (REFCorp) from
$300 million annually to 20 percent of net earnings.
The FHLBanks are required to pay the greater of 10
percent of net income or $100 million to the Affordable
Housing Program (AHP) and to provide discounted advances for targeted housing and community investment
lending through a Community Investment Program.
The FHLBS’ exposure to credit risk on advances has
traditionally been 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 to a member.
The System’s investment activities, including mortgage
purchase programs, create more risks. To control the
System’s risk exposure, the Finance Board 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 Finance Board conducts an annual on-site examination of each FHLBank. Each
FHLBank’s board of directors must establish risk-management policies that comport with Finance Board
guidelines.
The FHLBanks held $22.6 billion in mortgage loans
on September 30, 2001, approximately 3.3 percent of
total assets. The mortgage purchase programs offer
members alternative ways of doing mortgage business.
In one of these programs, the FHLBanks finance mortgage loans and assume the interest-rate and prepayment risks, while the members originate and service
the loans and assume most of the credit risk. All assets
held by an FHLBank under these mortgage purchase
programs are required, pursuant to the terms of the
program, to be credit enhanced to at least the level
of an investment-grade security. In addition, an
FHLBank must hold risk-based capital against mortgage assets that have credit risk equivalent to an instrument rated lower than double A.
The FHLBanks’ investment activities also pose important public policy issues about the degree to which
their asset composition adequately reflects the mission

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ANALYTICAL PERSPECTIVES

of the System. Although System investments other than
advances rose to $194 billion through September 2001,
compared to $178 billion a year earlier, as a percentage
of total assets, those investments remained at 28 percent. Like other Government Sponsored Enterprises
(GSEs), the System issues debt securities at close to
U.S. Treasury rates and invests the proceeds in higheryielding securities. In 2001, the FHLBS issued $4.9
trillion in debt securities. However, the majority of the
debt issued by the System is overnight or short-term,
but 73 percent of debt outstanding had an original maturity of one year or longer, and total debt outstanding
was about $611 billion at the end of 2001.

An enormous, liquid, and efficient capital market exists for conventional home mortgages today. As a result
of GSEs, Ginnie Mae, and the increasing presence of
private securitizers, lenders have access to substantial
liquidity sources, in addition to FHLBS advances, for
financing home mortgages. The GLB Act further increases access to the FHLBS for community financial
institutions with $527 million or less in assets by permitting advance borrowings that provide funds for
small businesses, small farms, and small agri-businesses.

Education Credit Programs and GSEs
The Federal Government guarantees loans through
intermediary agencies and makes direct loans to students to encourage post-secondary education. The Student Loan Marketing Association (Sallie Mae), a GSE,
securitizes guaranteed student loans.
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 (Direct Loan)
program. Eligible institutions of higher education may
participate in one or both programs. Loans are available to students regardless of income. Borrowers with
low family incomes are eligible for higher interest subsidies. For need-based Stafford Loans, the Federal Government subsidizes interest costs while borrowers are
in school, during a six-month grace period after graduation, and during certain deferment periods.
In 2003, more than 6 million borrowers will receive
nearly 11 million loans totaling $53 billion. Of this
amount, nearly $41 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 Federal Family Education Loan program provides loans through an administrative structure involving over 3,500 lenders, 36 State and private guaranty
agencies, roughly 50 participants in the secondary market, and approximately 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 2003, FFEL lenders will disburse more than 7 million loans exceeding
$35 billion in principal. Lenders bear two percent of
the default risk, and the Federal Government is responsible for the remainder. The Department also makes
administrative payments to guaranty agencies and pays
interest subsidies to lenders.
The William D. Ford Direct Student Loan program
was authorized by the Student Loan Reform Act of
1993. Under Direct Loans, the Federal Government pro-

vides loan capital directly to roughly 1,200 schools,
which then disburse loan funds to students. In 2003,
the Direct Loan program will generate more than 3
million loans with a total value of over $18 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 with any residual balances forgiven.
Consolidation Loans, which allow borrowers to combine one or more FFEL, Direct Loan, or other Federal
student loan into a single loan with a fixed interest
rate, have grown dramatically in recent years. In 1995,
Consolidation Loans totaled $3.6 billion, accounting for
roughly 13 percent of overall student loan volume. In
2001, the program had grown to more than $17 billion,
making up approximately 33 percent of all student loan
volume. This trend, which reflects a nearly five fold
increase from 1995 to 2001, is expected to stabilize.
Consolidation Loans are projected to be $17 billion in
2002 and decrease to $12 billion in 2003. The 2001
spike in Consolidation Loan volume resulted from lower
interest rates and a special discount offered to Direct
Loan consolidators.
For Fiscal Year 2003, the Administration is proposing
to address the shortage of qualified, skilled math,
science, and special education teachers in elementary
and secondary schools by increasing the amount of forgivable guaranteed and direct student loans from
$5,000 to $17,500 for highly qualified teachers who
teach math, science, or special education for five years
in high-need schools. This proposal builds upon the
teacher loan forgiveness program authorized in the
1998 Higher Education Amendments. High-need schools
would include those with a high concentration of lowincome students and those in which there is a large
proportion of out-of-field math, science, and special education teachers.
Sallie Mae
The Student Loan Marketing Association (Sallie Mae)
was charted by Congress in 1972 as a for-profit, shareholder-owned, Government-sponsored enterprise (GSE).
Sallie Mae was privatized in 1997 pursuant to the au-

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9. CREDIT AND INSURANCE

thority granted by the Student Loan Marketing Association Reorganization Act of 1996. The GSE is a wholly
owned subsidiary of USA Education, Inc. and must
wind down and be liquidated by September 30, 2008.
The Omnibus Consolidated and Emergency Supplemental Appropriations for 1999 allows the USA Education, Inc. to affiliate with a financial institution upon
the approval of the Secretary of the Treasury. Any affiliation will require the holding company to dissolve
the GSE within two years of the affiliation date (unless
such period is extended by the Department of the
Treasury).

Sallie Mae makes funds available for student loans
by providing liquidity to lenders participating in the
FFEL program. Sallie Mae purchases guaranteed student loans from eligible lenders and makes
warehousing advances (secured loans to lenders). Generally, under the privatization legislation, the GSE cannot engage in any new business activities or acquire
any additional program assets other than purchasing
student loans. The GSE can continue to make
warehousing advances under contractual commitments
existing on August 7, 1997. Sallie Mae currently holds
approximately 42 percent of all outstanding guaranteed
student loans.

Business and Rural Development Credit Programs and GSEs
The Federal Government guarantees small business
loans to promote entrepreneurship. The Government
also offers direct loans and loan guarantees to farmers
who may have difficulty obtaining credit elsewhere and
to rural communities that need to develop and maintain
infrastructure. Two GSEs, the Farm Credit System
(FCS) and the Federal Agricultural Mortgage Corporation (Farmer Mac), increase liquidity in the agricultural
lending market.
Small Business Administration
The Small Business Administration (SBA), created
in 1953, helps entrepreneurs start, sustain, and grow
small businesses. As a ‘‘gap lender’’ SBA works to correct market imperfections and provide access to credit
where private lenders are reluctant to do so without
a government guarantee.
The Administration’s 2003 Budget anticipates that
SBA’s lending programs will make available capital resources of over $16 billion. The 7(a) General Business
Loan program will support approximately $4.85 billion
in guaranteed loans, while the 504 Certified Development Company program will support $4.5 billion in
guaranteed loans. SBA will supplement the capital of
Small Business Investment Companies (SBICs), which
provide equity capital and long-term loans to small
businesses, with $7 billion in participating securities
and guaranteed debentures. In addition, SBA expects
to provide $26 million in microloans, along with $17
million in technical assistance to increase the probability of borrower success.
To continue to meet the needs of small businesses,
SBA will focus program management in three areas:
1) providing economic relief to small businesses, 2) improving risk management, and 3) operating more efficiently.
In the aftermath of the September 11th attacks, legislation was enacted to temporarily reduce fees for borrowers and lenders participating in the 7(a) General
Business Loan program. As a result, the annual fee
in the 7(a) program is reduced in half from 0.50 percent
to 0.25 percent and up-front fees in the 7(a) program
have been reduced in half to one percent for loans below
$150,000. For loans between $150,000 and $700,000,

the up-front fee was reduced to 2.5 percent (a reduction
of one percentage point), and for loans above 700,000,
the up-front fee remains at 3.5 percent.
As a result of the fee reductions, the subsidy rate
for the 7(a) program has increased to 1.76 percent in
2003 from 1.07 percent in 2002. This increase in cost
translates into a reduced program level of $4.85 billion
in 2003 from $9.3 billion in 2002. Given the additional
cost and limited resources, the Administration will target funds to creditworthy small businesses most likely
to be underserved by the commercial markets. While
SBA can guaranty loans up to $1 million, the greatest
need for government assistance is for loans below
$150,000. Loans below $150,000 are usually for very
small or start-up businesses. Lenders, however, are
generally reluctant to make these loans due to high
administrative costs and low financial returns. The SBA
guarantee, along with the reduction in fees, will encourage banks to increase the number of loans they make
that are below $150,000.
Measuring and mitigating risks in SBA’s $50 billion
business loan portfolio is one of the agency’s greatest
challenges. As SBA delegates more authority to the
private sector to administer SBA guaranteed loans,
oversight functions become increasingly important. SBA
has taken steps to improve oversight with the establishment of the Office of Lender Oversight, which will be
responsible for evaluating individual SBA lenders. This
office will employ a variety of analytical techniques to
ensure strong performance, including overall financial
performance analysis, industry concentration analysis,
peer lending performance comparisons, SBA portfolio
performance analysis, and selected credit reviews. The
oversight program will also encompass on-site safety
and soundness examinations and off-site monitoring of
the Small Business Lending Companies (SBLCs) and
compliance reviews of SBA lenders. This office will develop incentives for lenders to minimize defaults and
performance measures to monitor results.
SBA has been developing a Loan Monitoring System
(LMS) which will support lender oversight functions
by improving SBA’s data collection and processing capabilities, providing a better interface with lenders, and
helping to increase lender accountability. However,

192
after five years and more than $30 million, the LMS
project is behind schedule, over cost, and under performing. SBA will attempt to refocus the project to ensure successful implementation. The agency will refocus
the project and by March 2002, develop a detailed plan
for effective implementation.
Improving risk management also means improving
SBA’s ability to more accurately estimate the cost of
subsidizing small business loans. This will enable the
agency to allocate resources more effectively, determine
program risk more precisely, and increase the ability
to target programs to the neediest populations. The
Administration has made significant progress in improving the accuracy of the subsidy estimate in the
7(a) program. Reflecting long-term changes in the program, the 2003 budget uses an improved estimation
method, resulting in a reduced program cost. To refine
the estimation in future years, SBA is developing an
econometric model, which integrates a variety of programmatic and economic changes that affect loan performance. SBA is also reviewing the cost estimation
method for the 504 Certified Development Company
Program.
To operate more efficiently, SBA will automate loan
origination activities in the disaster loan program with
a paperless loan application. As a result, loan-processing costs, times, and errors will decrease, while government responsiveness to the needs of disaster victims
will increase. While still in the design stage, SBA expects to begin full implementation of the paperless disaster loan application in 2003. Additionally, because
loan-servicing functions can be better performed by the
private sector, SBA is privatizing these activities. The
agency will therefore, focus its resources on core programs such as providing access to capital, technical
assistance, and federal contracting opportunities. SBA
is selling its current portfolio of defaulted guaranteed
loans and direct loans. The agency has already sold
more than $4 billion in such loans and will begin to
reflect human resource and cost efficiencies that result
from these sales.
Still, with all of these management improvements,
Government should only foster, not replace private-sector investment. As such, the Administration continues
to seek alternative and innovative ways to support
small business development. For instance, the advent
of interstate banking and the Gramm-Leach-Bliley Financial Modernization Act of 1999 have expanded small
businesses’ access to capital. Banks have greater liberties to engage in merchant banking activities, including venture capital investments, allowing them to support small businesses in a variety of ways. While the
Small Business Investment Company program has been
effective in providing patient capital to small businesses, the venture capital market has matured over
the last twenty years and may no longer need the same
level of government intervention.
Another way to support small business development
is to provide financing opportunities beyond the limited
7(a) loan program, which historically has served less

ANALYTICAL PERSPECTIVES

than one-tenth of one percent of the Nation’s small
businesses annually and provided less than one percent
of annual small business lending. The Administration
will work with the Congress, the lending community,
and the small business communities to explore new
approaches to insure that a greater number of the Nation’s small businesses have adequate access to capital.
One possible model is Capital Access Programs (CAPs).
Many States participate in CAPs, but the programs
are managed largely by private parties. Under a CAP
program, the bank and the borrower pay an up-front
insurance premium typically between three and seven
percent of the loan amount into a reserve account,
which is matched by the participating state government. CAPs or other innovative state programs that
place greater emphasis on market solutions may point
the way toward modernizing and complementing SBA’s
lending programs.
USDA Rural Infrastructure and Business Development Programs
USDA provides grants, loans, and loan guarantees
to communities for constructing facilities such as
health-care clinics, day-care centers, and water and
wastewater systems. Direct loans are available at lower
interest rates for the poorest communities. These programs have very low default rates. The cost associated
with them is due primarily to subsidized interest rates
that are below the prevailing Treasury rates. The program level for the Water and Waste (W&W) loan and
grant program in the 2003 President’s Budget is $1.5
billion. These funds are available to communities of
10,000 or less residents. The program finances drinking
water, sewer, solid waste disposal, and storm drainage
facilities through direct or guaranteed loans and grants.
In order to qualify, applicant communities must be unable to finance their needs through their own resources
or with credit from commercial lenders. Priority is given
to loans serving smaller communities that have greater
financial need, based on their median household income, poverty levels, and size of service population as
determined by the USDA’s field office staff. The community typically receives a combination of loans and
grants depending on how much they can afford. The
grant is usually for 35–45 percent of the project cost
(it can be up to 75 percent). Loans are for 40 years
with interest rates based on a three-tiered structure
(poverty, intermediate, and market) depending on community income. The community facility programs are
targeted to rural communities with fewer than 20,000
residents and have a program level of $477 million
in 2003. USDA also provides grants, direct loans, and
loan guarantees to assist rural businesses, including
cooperatives, to increase employment and diversify the
rural economy. In 2003, USDA proposes to provide $700
million in loan guarantees to rural businesses (these
loans serve communities of 50,000 or less).
These community programs are all part of the Rural
Community Advancement Program (RCAP). Under
RCAP, States have increased flexibility within the three

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9. CREDIT AND INSURANCE

funding streams for Water and Wastewater, Community Facilities, and Business and Industry (B&I). USDA
also provides loans through the Intermediary Rel