Commentary

America’s budget book-keeping scandal

By Jagadeesh Gokhale and Kent Smetters
This article originally appeared in the Financial Times on September 9, 2003.
California’s bond rating has sunk to a level just above junk status - the lowest grade among all 50 states - as it struggles through its budget crisis. California is teaching the rest of the US a valuable lesson about the connection between fiscal policy and financial markets. Unfortunately, it may again be setting a trend for the nation: unless action is taken very soon to reform the main US benefit programmes, Washington may have to grapple with the same crisis currently preoccupying Sacramento.

Unresolved, the situation could cause US Treasury yields to rise sharply, wreaking havoc on the national economy.

As with California’s budget, the US federal budget is not easy to decipher. The main problem is that it hides future shortfalls associated with Medicare and Social Security. The combined net shortfall of both these programmes is already large and is growing at an alarming rate, at about $1,500bn on average each year.

Such large shortfall estimates are nowhere to be found in federal budget reports produced by the Congressional Budget Office and by the President’s Office of Management and Budget. The reason is that the CBO’s and OMB’s “unified budget” simply adds up all the revenue that the federal government collects in a given year and then subtracts the outlays. Growth in the unfunded obligations of programmes such as Medicare, Social Security, Medicaid, federal employee pensions, and other federal programmes are not counted.

To understand the problem, suppose your 18-year-old kid moved out of your house last month and got a job to cover his rent. He made $2,000 in the month and paid $1,000 in rent. Food and utilities cost another $800. On a cash flow basis, everything appears great. He has $200 left over to put into the bank. But your opinion of his financial position would change if you also discovered that he had built up another $500 in credit card charges during his first month and that he planned on doing so every month into the future. You would wisely inform him that he was actually $300 in the red and that he should quickly change his spending habits.

Unfortunately, the budgeting by the US federal government does not take into account the growing “credit card” debt that is being created by the nation’s large entitlement programmes. If it did, CBO and OMB would report the official deficit closer to $1,600bn (covering all government programmes) rather than the $400bn that these agencies reported for fiscal year 2003 or the $480bn or so they project for fiscal year 2003.

Politicians and voters would no longer be arguing about “small potatoes” such as the impact of the recent tax cuts on the deficit. Instead, everyone would be focusing on what really matters: reforming the nation’s entitlement programmes in order to make sure they can truly be sustained into the future.

Alas, Congress is doing just the opposite. The House and Senate will be in conference committee this autumn, trying to iron out differences between House and Senate bills over a new Medicare prescription drug benefit. To be sure, a Medicare system without prescription drug coverage creates a lot of distortions. But the new benefit currently being discussed in committee would not reform Medicare as needed. Instead, it would cost more than 40 times the value of the newest tax cut, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (assuming the provisions in that Act are actually allowed to expire as stated in the law).

Only the government, it appears, can get away with such faulty accounting: it is illegal for private companies’ bookkeepers to ignore their future pension and healthcare liabilities. To be sure, as explained in our book*, the proper method of accounting for the federal government’s future obligations must necessarily be different from that which is appropriate for the private sector. But for Congress to ignore outright the rapid growth in future pension and healthcare obligations in its budget seems indefensible. Now that we have adopted the Sarbanes-Oxley law and other key regulatory reforms to deal with shortcomings in private sector book-keeping, it is time to pay attention to the federal government’s own budget accounting.

*Fiscal and Generational Imbalances, AEI Press

Jagadeesh Gokhale is a visiting scholar at the American Enterprise Institute and Kent Smetters is assistant professor at the University of Pennsylvania.