Budget Issues: Budgeting for Inflation in Civilian Agencies (Staff Study,
10/01/1999, GAO/AIMD-00-14).

GAO reviewed the Department of Defense's (DOD) experiences with
budgeting for inflation, focusing on whether it is feasible for civilian
agencies to also budget for inflation.

GAO noted that: (1) for a number of reasons, DOD has experienced greater
changes in purchasing power due to inflation and has a better ability to
track these changes than civilian agencies; (2) more specifically, DOD
is able to identify changes in inflation because of three factors not
found in most civilian agencies: (a) large dollar amounts structured by
function that can be aggregated to a relatively few account titles; (b)
a budget planning process that spans multiple years and serves as a
baseline for measuring change; and (c) full funding for major weapons
systems and other large procurements, which provides appropriations up
front for the total estimated cost of a program or project at the time
it is undertaken regardless of when the funds will actually be
obligated; (3) in contrast, civilian agencies, for a number of reasons,
have less potential to experience large changes in purchasing power due
to a change in estimated inflation rates, and have a difficult time
tracking fluctuations in inflation; (4) one reason is that funding for
capital assets in civilian agencies, with few exceptions, is
fundamentally different than in DOD; (5) for the most part, civilian
procurement is funded on an incremental basis, that is, only for the
amount that is expected to be obligated during the first year; (6) thus,
no matter the size and length of the procurement, the annual budget
process provides a regular opportunity to reassess (and reestimate for
such factors as changes in inflation) an agency's funding requirements;
(7) in addition, while 40 percent of federal procurement activities are
carried out by civilian agencies, they are spread over approximately 700
disparately structured accounts across many agencies and individual
contracts; and (8) taking these factors into consideration, requiring
civilian agencies to track changes in inflation would not be
cost-effective.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD-00-14
     TITLE:  Budget Issues: Budgeting for Inflation in Civilian
	     Agencies
      DATE:  10/01/1999
   SUBJECT:  Defense budgets
	     Comparative analysis
	     Inflation
	     Cost effectiveness analysis
	     Defense procurement
	     Future budget projections
	     Budget administration
	     Federal procurement
IDENTIFIER:  DOD Future Years Defense Program

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Staff Study

October 1999

BUDGET ISSUES

Budgeting for Inflation in Civilian Agencies
*****************

*****************

GAO/AIMD-00-14

PREFACE
=======

In recent years, the Department of Defense (DOD) has experienced increases
in purchasing power (called inflation dividends) that occur when inflation
is lower than had been projected at the time funds were requested. DOD has
used those savings to fund a larger program without requesting or
receiving additional resources. In 1998, DOD calculated that lower-than-
expected inflation would reduce fiscal years 1999 through 2003 procurement
costs, i.e., nonsalary purchases, by $21.3 billion compared to what had
been projected 1 year earlier./Footnote1/ Of this amount, $2.8 billion, or
approximately 1 percent of DOD's annual budget, was savings estimated for
fiscal year 1999. DOD was allowed to keep these savings and, in some
cases, authorized to redirect funds to programs and purposes other than
those originally planned, authorized, and appropriated. 

Given DOD's experience, the question of whether civilian agencies should
also identify the effect of lower inflation on their funding requirements
has been raised. To understand better the challenges to developing this
capability in civilian agencies, this staff study describes how inflation
is treated currently in budgeting for DOD and civilian discretionary
nonpay activities. We developed case studies in three civilian agencies:
the Department of the Interior's Bureau of Land Management (BLM), the
Department of Energy's (DOE) Office of Environmental Management, and the
National Aeronautics and Space Administration (NASA). We also reviewed our
prior work pertaining to inflation changes in both civilian agencies and
DOD and obtained written responses from DOD to questions on how it budgets
for inflation. We have not included a discussion of funding for civilian
and military pay because decisions on annual increases are not tied to the
rate of inflation. However, these costs can be more significant than the
costs associated with nonpayroll-related inflation since federal agencies
are required to absorb these increases. 

Results in Brief

For a number of reasons, DOD has experienced greater changes in purchasing
power due to inflation and has a better ability to track these changes
than civilian agencies. More specifically, DOD is able to identify changes
in inflation because of three factors not found in most civilian agencies:
(1) large dollar amounts structured by function that can be aggregated to
a relatively few account titles,/Footnote2/ (2) a budget planning process
that spans multiple years and serves as a baseline for measuring change,
and (3) full funding for major weapons systems and other large
procurements, which provides appropriations up front for the total
estimated cost of a program or project at the time it is undertaken
regardless of when the funds will actually be obligated. 

In contrast, civilian agencies, for a number of reasons, have less
potential to experience large changes in purchasing power due to a change
in estimated inflation rates, and have a difficult time tracking
fluctuations in inflation. One reason is that funding for capital assets
in civilian agencies, with few exceptions, is fundamentally different than
in DOD. For the most part, civilian procurement is funded on an
incremental basis, that is, only for the amount that is expected to be
obligated during the first year. Thus, no matter the size and length of
the procurement, the annual budget process provides a regular opportunity
to reassess (and reestimate for such factors as changes in inflation) an
agency's funding requirements. In addition, while 40 percent of federal
procurement activities are carried out by civilian agencies, they are
spread over approximately 700 disparately structured accounts across many
agencies and individual contracts. Taking these factors into
consideration, requiring civilian agencies to track changes in inflation
would not be cost-effective.

Background

The issue of budgeting for inflation was first addressed in response to
escalating inflation, primarily in DOD programs. Although, since 1982, DOD
inflation estimates have often been higher than actual inflation, the
reverse was true in the late 1960s and 1970s when the Administration
systematically underestimated inflation in its budget requests to the
Congress. (See "Related GAO Products.") Until the 1970s, only shipbuilding
appropriations allowed for anticipated inflation. By the mid-1970s, in
reaction to escalating inflation, the Administration proposed in the
President's Budget request and the Congress allowed DOD to include an
inflation allowance for certain categories of expenditures, first for
major weapon systems, then fuel, and finally for all military procurement
and construction spending. Eventually, defense and civilian agencies were
allowed to include estimates for the cost of inflation in agency operating
accounts as well.

As the rate of inflation declined, concerns shifted to the issue of
overfunding for inflation. Beginning with DOD's fiscal year 1987
authorization act,/Footnote3/ the Congress required DOD to monitor and
report on changes in inflation three times a year. No comparable
requirement existed for civilian agencies. Although this requirement was
eliminated in fiscal year 1989 when projected savings were in decline, DOD
continues to identify changes in inflation and adjust its estimates as
necessary for its annual submission to the President's Budget and the
Office of Management and Budget's (OMB) Mid-Session Review./Footnote4/

In the 1990s, especially in recent years, spending caps have limited the
amount of funding available for defense and civilian discretionary
programs. The Budget Enforcement Act/Footnote5/ established dollar caps on
discretionary spending for fiscal years 1991 through 2002, which, until
fiscal year 1998, were adjusted for inflation. Since then, budget
authority and outlay caps in particular are almost level in dollar terms
from fiscal year 1998 through fiscal year 2002./Footnote6/ Thus, not all
agencies are funded at a level sufficient to keep pace with inflation. As
a consequence, while lower inflation may, in some instances, increase the
level of resources over what was planned, it does not necessarily produce
a windfall for these agencies. Instead, it reduces the size of program
cuts that need to be made to stay within funding levels and overall
spending caps. 

Budgeting for Inflation in the Department of Defense

Although DOD does not explicitly identify estimated inflation in its
budget request, its functional structure and large account titles enable
it to apply inflation factors to its accounts and to calculate the effect
of any subsequent changes. In addition to DOD's account structure, two
other attributes help identify large savings (or losses) from changes in
inflation: (1) a 5-year planning baseline from which to measure
adjustments and
(2) full funding of major procurements, which provides funding at the time
a project is undertaken and increases the base on which inflation factors
are applied. 

The account structure of DOD is organized by function. In contrast,
civilian agencies' accounts are characterized by a mix of account
orientations with an emphasis on programs and processes. For example,
DOD's primary accounts are made up of the following functional areas:
Military personnel; Operation and maintenance; Procurement; Research,
development, test, and evaluation; Military construction; and Family
housing, as well as Revolving and management funds. DOD builds inflation
into its budget and its long-term planning document-the Future Years
Defense Program (FYDP)-and makes annual adjustments to inflation using
these large account titles. 

DOD also is the only agency that has a long-term, structured budget
planning process that covers a 5-year period and is adjusted annually. DOD
constructs its budget request and FYDP on the basis of the
Administration's economic assumptions provided for the previous year's
budget. For example, the budget for fiscal year 2000 is developed assuming
the rate of inflation contained in the fiscal year 1999 budget, but is
revised to reflect current economic assumptions in December just before
the President's Budget is released. DOD uses one overall price index for
all nonpayroll purchases except fuel. DOD applies the difference between
the old rate and the new to each primary account using a formula based on
projections of future inflation rates and the projected rate of spending
for components within the accounts. 

DOD's long-term planning estimates assume full funding for most DOD
procurement programs. DOD procurement represents about 60 percent of total
federal procurement activity. When a contract is fully funded, the total
cost of the project (or a useful project segment) is estimated using
current economic assumptions and the entire amount of budget authority is
provided in the first year. Although DOD fully funds most procurement
programs, DOD's ability to track changes caused by fluctuations in
projected inflation provides an opportunity to review and adjust funding
levels in the same way that the annual budget process provides a check on
incrementally funded programs. 

Budgeting for Inflation in Civilian Agencies

Funding for inflation generally is not requested, funded, or tracked
separately in civilian agencies' nonpersonnel, discretionary budget
requests. Although agencies are expected to build inflation into their
submissions to OMB, there is no single inflation rate that applies across
all agencies and the approximately 700 civilian accounts with procurement
activities. Agencies include inflation in their estimates but, especially
in recent years, they cannot assume that they will get sufficient funding
to cover inflation because of discretionary spending limits. According to
OMB officials, OMB usually allows an agency to decide how best to absorb
inflation costs. Although civilian agencies fund 40 percent of federal
procurements, funding is appropriated annually in increments so that there
are opportunities to adjust for inflation in annual appropriations. Even
when inflation rates are more favorable than estimated, not all contracts
allow for inflation adjustments, and, in the agencies we studied,
inflation is only one of several cost drivers. 

OMB requires that agencies build inflation into their budget estimates,
but not as a separate cost item. Civilian agencies are instructed in OMB
Circular A-11, Preparation and Submission of Budget Estimates, to use
budget year numbers for nonpay costs (i.e., agencies project estimates for
their fiscal year 1999 budget request in 1999 dollars, not in 1997
dollars, when the estimate is prepared). Civilian agencies thus build
inflation into their estimates. Notwithstanding, OMB policy states that
consideration of price changes as a factor in developing estimates does
not necessarily mean that the full rate of anticipated inflation should be
included automatically./Footnote7/

Agencies build inflation into their funding requests to OMB by estimating
what nonpay costs will be in the future budget year using a variety of
indices and assumptions. Civilian agencies, with the concurrence of OMB,
may use more than one type of price index to estimate inflation. These
indices are based on program specific factors, such as local market
conditions or product requirements. For example, NASA uses indices that
represent a weighted average of Data Resources Incorporated (DRI) indices
and the consumer price index for new initiatives. NASA's inflation index
tends to be 1 to 2 percent higher than the gross domestic product price
index due to NASA's reliance on relatively high labor rates and exotic
materials. In another example, DOE's Office of Environmental Management
has developed six specialized escalation models for tracking inflation and
other factors that affect the costs of projects. 

Caps on discretionary spending have made it less likely that an agency's
funding level will accommodate increases for inflation. The Department of
the Interior's budget submission, which includes BLM, identified certain
expenses, such as rent increases, security and communications charges, and
working capital fund charges, as "uncontrollable," and separated these
changes in expenses from other programmatic changes. Displaying
adjustments in what it calls uncontrollable expenses allows Interior to
identify inflation separately. However, OMB officials told us that this
type of budget detail has become increasingly irrelevant as annual caps
hold many agencies' budgets at or below a level that accommodates
inflation. Generally, only high-priority programs receive funding to
accommodate inflation. Also, since federal agencies are required to absorb
mandatory pay increases, fewer funds are available for procurement
activities. Accordingly, it cannot be assumed that a reduction in expected
inflation will produce a funding windfall if inflation was funded
partially or not funded at all. 

Most civilian agencies receive incremental funding for procurement
activities, that is, they receive funding on a year-to-year basis. The
annual budget cycle and the yearly revisions of inflation estimates
provide opportunities for the Congress to consider inflation in making
funding decisions for civilian agencies, although here too, discretionary
caps limit the amount of funds available. 

During contract performance, as opposed to during an agency's budgeting
cycle, savings that occur due to a change in projected inflation do not
always accrue to the government. The contract terms determine whether the
contractor or the government bears the inflation risk and thus incurs the
costs or reaps the benefits from a change in inflation during contract
performance. For example, in firm fixed-price contracts, the contractor is
typically at risk for all aspects of contract performance and so incurs
the costs or benefits associated with changes in inflation that are higher
or lower than expected./Footnote8/ Thus, any inflation dividend accrues to
the contractor, not the contracting agency. Of the agencies we studied,
only BLM primarily uses fixed-price contracts. BLM contracts for services
and supplies, such as hazardous materials removal, road construction and
restoration, and fire engines.

For cost reimbursement contracts (these include cost plus fixed fee, cost
plus incentive fee, or cost plus award fee contracts), the government
bears the risk of inflation during contract performance and any inflation
dividend would accrue to the government. Thus, where funds are allocated
to a contract based on its estimated costs, including inflation, and
inflation is less than expected, the government receives an "inflation
dividend" vis-a-vis its budget estimate. This is more likely to occur in
complex procurements involving multiyear contracts, such as those that
occur in DOD. The majority of NASA's procurement dollars involve cost
reimbursement contracts, which are primarily associated with the Space
Shuttle and Space Station. DOE's Office of Environmental Management also
primarily uses cost reimbursement contracts.

In the current economic environment, inflation is only one cost driver
nested among other more significant cost drivers, such as changing
technology or availability of materials and labor. Officials at NASA's
Langley Research Center stated that they use a "guideline audit trail" to
track monthly changes in costs, but they do not track the details of those
changes. An official at another agency stated that with inflation rates as
low as they are at present, inflation currently is not a major factor in
the escalation of costs. This official also stated that over time and over
the development of a project, inflation virtually gets lost. 

In our earlier report on budgeting for inflation in DOD, we stated that it
is not clear that monitoring inflation below the appropriation account
level would be helpful or useful./Footnote9/ We believe this applies to
civilian agencies as well. DOD, like civilian agencies, uses a variety of
contract types, but because DOD is able to build, track, and adjust
inflation using a small number of large account titles, it does not need
to go below the primary account level to identify savings or losses due to
changes in inflation. DOD's planning process, in addition to providing a
baseline for measuring changes over multiple years, provides a top-down,
integrated perspective. Thus, savings (or losses) due to changes in
inflation can be viewed in the context of overarching decisions on the
appropriate level of funding for DOD in any single budget year. 

It would be difficult and, we believe, not cost-effective to require
civilian agencies to monitor changes in inflation. This conclusion is
based on several considerations: (1) the large number of small pools of
resources potentially affected across multiple civilian agencies and
contracts, (2) the variety of inflation assumptions used by civilian
agencies in developing estimates, (3) obstacles to developing a baseline
from which to measure savings and losses, including separating inflation
from other cost drivers, (4) the current environment of low, stable
inflation coupled with caps on discretionary spending, and (5) the
prevalence of incremental appropriations for civilian procurement that
permits adjustments already.

On September 13, 1999, we provided the Departments of Defense, Energy, and
Interior, as well as NASA and OMB, a draft of this staff study for review
and comment. Between September 22 and October 5, 1999, all of the
reviewers informed us, either orally or in writing, that they agreed with
the information presented and had no comments. 

For future contacts regarding this staff study, please contact Paul L.
Posner at (202) 512-9573. Individuals making key contributions to the
study included Denise M. Fantone, Hannah Laufe, and Marcus Melton.

--------------------------------------
/Footnote1/-^When we started this study, DOD projected the cost of
  nonsalary purchases would grow by an average of 2.1 percent per year for
  1999 through 2003. DOD's most recent projections, in its 2000 Future
  Years Defense Program (FYDP), are 0.8 percent for 1999, 1.5 percent for
  2000, and 1.6 percent for 2001 through 2003. 
/Footnote2/-^A DOD account title (or primary account) consists of all
  functionally related appropriations accounts. For example, DOD's
  Procurement account title in the President's Fiscal Year 2000 Budget
  includes 20 appropriations accounts, such as, Procurement of ammunition,
  Army; Weapons procurement, Navy; and Missile procurement, Air Force.
/Footnote3/-^The National Defense Authorization Act for Fiscal Year 1987,
  Public Law 99-661, 100 Stat. 3980-81 (1986).
/Footnote4/-^The President is required to transmit a supplemental update
  to the President's Budget sent to the Congress the previous February.
  This supplemental contains revised estimates of the budget receipts,
  outlays, and budget authority for the current fiscal year and the next 5
  fiscal years. 
/Footnote5/-^The Budget Enforcement Act of 1990 and subsequent amendments
  (the Omnibus Reconciliation Act of 1993 and the Budget Enforcement Act
  of 1997) are collectively referred to as the Budget Enforcement Act
  (BEA). These acts amend the Balanced Budget and Emergency Deficit
  Control Act of 1985 (the Deficit Control Act).
/Footnote6/-^The rate of inflation was approximately 3.4 percent in fiscal
  year 1991 and gradually decreased to approximately 2.6 percent in fiscal
  year 1997. According to the Congressional Budget Office, if 1999
  appropriations equaled 1998 budget authority adjusted for inflation,
  total outlays (including those from previously enacted appropriations)
  for both defense and nondefense would exceed their respective
  discretionary caps by about $8 billion. 
/Footnote7/-^Every budget year, OMB issues a set of economic assumptions
  that agencies use to formulate the current services baseline. The
  current services baseline reflects the projected costs of continuing
  federal programs without any policy changes and is included in the
  President's Budget as one of several analytical presentations. Although
  civilian agencies are required to use OMB's economic assumptions to
  construct this baseline, agencies are expected to use nonpersonnel
  inflation assumptions that best reflect their programs in their budget
  submissions to OMB. 
/Footnote8/-^Some fixed-price contracts have economic price adjustment
  clauses that allow the contractor to be reimbursed for uncontrollable
  costs, including inflation. For example, some BLM contracts include
  economic price adjustment clauses, such as lease escalator clauses or
  operating cost escalator clauses (for use with services and utilities).
/Footnote9/-^DOD Inflation: Budgeting and Monitoring Inflation Funding in
  the Department of Defense (GAO/NSIAD-88-79, April 26, 1988).

SCOPE AND METHODOLOGY
=====================

We developed case studies in three civilian agencies: the Department of
the Interior's Bureau of Land Management, the Department of Energy's
Office of Environmental Management, and the National Aeronautics and Space
Administration. Since purchasing power increases or decreases due to
changes in inflation, entities that spend a large proportion of their
budgets on multiyear procurements will potentially experience greater
changes due to inflation than those that do not. We therefore selected
entities with relatively large dollar volumes of contracting activity,
relatively large contracts, and highly centralized procurement and budget
activities. We based our selections on information derived from interviews
with officials at OMB, analysis of budget and procurement data pertaining
to the case studies, and consultation with congressional staff.

We interviewed OMB staff familiar with OMB executive branch budget
policies and procedures to get a governmentwide perspective on recent
trends in funding for inflation in civilian agencies. For those programs
selected for further study, we interviewed the agencies' OMB program
examiners, agency budget and procurement staff, project managers, and, for
some programs, cost estimators. We also reviewed our prior work pertaining
to inflation changes in both civilian agencies and DOD, and obtained
relevant reports from the Congressional Budget Office and the
Congressional Research Service. DOD provided us with written responses to
questions on how it budgets for inflation. We also looked at broad trends
in discretionary funding to provide context for our work. Our work was
performed in Washington, D.C., and Hampton, Virginia, from August 1998
through August 1999 in accordance with generally accepted government
auditing standards.

RELATED GAO PRODUCTS
====================

1999 DOD Budget: DOD's Procurement and RDT&E Programs (GAO/NSIAD-98-216R,
August 14, 1998).

Department of Energy: Office of Environmental Management's and Defense
Programs' Fiscal Year 1999 Budget Requests (GAO/RCED-98-213R, July 24,
1998).

Defense Budget: Projected Inflation Savings (GAO/NSIAD-98-177R, 
May 11, 1998).

Future Years Defense Program: Lower Inflation Outlook Was Most Significant
Change From 1996 to 1997 Program (GAO/NSIAD-97-36, December 12, 1996).

DOD Budget: Controls Needed Over Inflation Dividends (GAO/NSIAD-93-62BR,
December 14, 1992).

DOD Inflation: Budgeting and Monitoring Inflation Funding in the
Department of Defense (GAO/NSIAD-88-79, April 26, 1988).

Budget Issues: Budgeting for Inflation in Selected Civil Accounts
(GAO/AFMD-86-34BR, March 20, 1986).

Budget Issues: Potential for Excess Funds in DOD-March 1986 Update
(GAO/NSIAD-86-76, March 7, 1986).

Potential for Excess Funds in DOD (GAO/NSIAD-85-145, September 3, 1985).

(935320)

*** End of document. ***