Cato Policy Analysis No. 19 October 21, 1982

Policy Analysis

The Underground Federal Government:
Bane of the Balanced Budget?

by James T. Bennett and Thomas J. DiLorenzo

James T. Bennett is Professor of Political Economy and Public Policy, and Thomas J. DiLorenzo is Assistant Professor of Economics, George Mason University, Fairfax, Virginia.

Executive Summary

In recent years both academics and the popular press have shown a growing interest in the "underground economy" -- the volume of transactions that involve payment in money or in other goods (barter) but which are not recorded in official statistics. The transactions may not be recorded because they are illegal, such as narcotics and prostitution, or because taxpayers simply refuse to pay in full their ever-increasing tax bills. The growth of the underground private economy is perhaps the ultimate stage of the "tax revolt of the '70s." Numerous constitutional and statutory limitations were imposed on state and local government taxing and spending powers, and 31 state legislatures voted to convene a convention to adopt a balanced budget amendment to the U.S. Constitution.

Tax-imposed constraints on one's ability to accumulate wealth (or to just break even) have induced American taxpayers to conceal literally hundreds of billions of dollars from the purview of the tax collector. Some of the policy implications of the recent excavations of the underground private economy are both powerful and straightforward: We have grossly under-stated actual levels of employment, income, output, savings, and productivity, which renders various "stimulative" spending policies misdirected at best. The economy may be far healthier than generally believed.

Much of the writing and research on the tax revolt of the 1970s has focused on the "first stage" of the revolt -- Proposition 13-type tax limitations -- and the second stage -- growth of the underground economy. There is a third stage, however, that has received much less attention. It involves the question of how politicians, who are, of course, every bit as calculating as the ordinary citizen, have responded to recently imposed constraints on their abilities to accumulate wealth and power through the political process. In general, for nearly a century state and local governments have responded to various taxpayer revolts and the accompanying spending, taxing, and borrowing limitations by giving lip service to fiscal responsibility while simultaneously creating scores of "off-budget enterprises" (OBEs) through which they can conduct "business as usual." Taxpayer demands for fiscal responsibility have also spawned the growth of the off-budget activities of the federal government. In short, just as tax-imposed constraints on individual incomes have created a burgeoning underground private economy, taxpayer-induced constraints on the politician's ability to parlay the public sector to his personal advantage, at taxpayer expense, have generated the growth of an "underground government" at all levels. Thus, the size and influence of the public sector of the economy is much larger than generally believed. This paper examines the activities of the underground federal government in particular, and discusses the implications of "off-the-books" government activity for efforts to secure a balanced-budget amendment.

There are three basic ways in which, through the credit markets, federal spending is kept off the budget. First, numerous agencies are simply not included in the budget. Second, government control is extended over resource allocation by guaranteeing loans made to specially privileged individuals, businesses, and governments. Third, there are numerous privately owned, but federally sponsored and controlled, enterprises such as the Federal National Mortgage Association, that are also off-the-books borrowers.

In addition to manipulating credit market activities, politicians have increasingly recognized that, in principle, anything that can be accomplished through taxing and spending can also be accomplished with regulation. All of these activities must be taken into account to assess accurately the role of the federal government in the economy.

The Congressional Budget and Impoundment Control Act of 1974 has been praised by U.S. News & World Report as a "revolutionary budget reform intended to give Congress a tighter grip on the nation's purse strings."[1] The Budget Reform Act emerged from a recognition that existing budgetary procedures generated a bias toward overspending and budget deficits. Prior to 1974, the total amount of federal spending was the product of many individual appropriations decisions; no explicit limit was ever placed on the total amount of public expenditure. Each congressman had then, as he does now, a very strong incentive to maximize spending for his own voting constituency, but no congressman was required to take responsibility for the total amount of federal spending that resulted from the appropriations process. The Budget Reform Act created a budget committee for each house responsible for setting overall targets for revenues, expenditures, and the resultant deficit (or surplus). The Congressional Budget Office was created to assist in this process.

The main impact of the Budget Act is to make taxing, spending, and deficit levels explicit and to hold Congress accountable for them; the Act itself does nothing to curb spending. In keeping with the traditions established at the state and local levels of government, the relatively mild budgetary discipline of the Budget Act elicited a great deal of "back-door spending" at the federal level. In the wake of the Budget Act, numerous agencies have been and continue to be placed off-budget and beyond the purview of any appropriations process. Thus, while the Congress was publicly proclaiming a need for fiscal discipline in federal budget matters and enacting legislation to deal with the problem of "uncontrollable" spending, it was simultaneously establishing mechanisms through which spending could be placed off-budget. Off-budget federal outlays, by agency, since 1973 are shown in Table 1. Although the estimated $32.2 billion in off-budget outlays in 1981 was only about 5 percent of the federal budget, this amount has increased by an astounding 32,200 percent since 1973.

Most recently, the Synthetic Fuels Corporation, which began operations in 1981, was also placed off-budget. Congress had previously authorized $20 billion for the development of this "industry." The penchant for back-door federal spending is obviously nonpartisan. Both the Democratic-controlled House and the Republican-controlled Senate, at the insistence of the Reagan administration, voted to place the Strategic Petroleum Reserve "off-the-books." There have even been bipartisan proposals for dealing with the social security crisis by placing the Social Security program, with over $220 billion in expenditures in 1982, off-budget!

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