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Capital Budgeting

When the scandal over an Air Force plan to lease a fleet of next-generation aerial tankers from Boeing, rather than buy them outright (scandalous because the long-term price tag for leasing was far higher than for a purchase — and because, it turned out, the contracting officer at the Defense Department was already soliciting a job at Boeing while the deal was being struck), David Brooks wrote a column for the New York Times using it as a touchstone for discussion of the moral corruption inherent in modern politics.

I agreed with his point but, for me, the episode (setting aside the scandal) was also illustrative of a more general problem in the way governments — and particularly the federal government — make financial and budgetary plans for the future. I wrote this letter to Mr. Brooks to suggest that problem as a topic for a future column. I have not seen it yet.

28 October 2003

I agree with you that the aircraft leasing deal probably stinks financially and that the politics demonstrated the worst aspects of our legislative processes, but the source of it all — the shortage of funds to buy the planes outright — deserves more discussion than the one sentence you gave it. I recognize that the thrust of your column was the moral corruption of politics, not the intricacies of defense or fiscal policy; perhaps a future column could take those on directly.

As I see it, the problem is not just a question of whether or not this year’s or next year’s defense budget is sufficient to buy rather than to lease. There is a debate to be waged over military spending and strategies, but this goes beyond that. This is really more about a systemic problem of how the federal government manages capital expenditures.

The Air Force proposal is really not different in kind than what most of us do when we buy a home or a car (or even a couch or a refrigerator) on credit. We know (or at least most of us do) that, over the long term, it costs us a lot more to buy that way than to pay cash; and, for the most part, we would prefer to pay cash and reap the savings. But we generally have the same problem the Air Force does at the moment: we want the house or the car (or the tankers) now but don’t have the up-front capital to buy them outright, either because it doesn’t exist or because it is tied up in a reserve to cover cash-flow contingencies. Businesses behave similarly: they take loans or sell bonds or issue stock to raise capital for things like factory upgrades and expansion, generally paying more over time than they would if they had paid cash but preserving their cash reserves to cover operating expenses and economic downturns.

Small town governments face the same dilemmas on a regular basis and use the same solution. Every few years, they need to spend a chunk of money for a new fire engine. Every decade or two they need to replace a school or a town hall or a library or a water or sewer system. In none of those cases is it reasonable to raise all the necessary funds from the tax-base in a single year, nor does it generally prove practical to save for them over time — any indication that government is collecting more than it is spending generally elicits calls for immediate tax cuts, notwithstanding the benefits of a capital reserve fund. Instead, they sell project-specific capital bonds to finance the up-front costs and pay them off with interest over time. State governments do the same for roads and other projects.

As far as I know, however, the federal government makes very little effort to differentiate, at least at the full budget level, capital and operating expenses. The Air Force can’t sell “tanker bonds”. That isn’t to say that the federal government doesn’t borrow money — it has traditionally been addicted to it. It just means that neither the Executive nor the Legislature seems to make any serious effort to separate long-term one-time expenditures from ongoing commitments. They sell bonds, but proceeds go into the general fund and are allocated by the political whim of the moment rather than according to any capital improvement strategy. Among the results is chaos when even trying to discuss the pros and cons of deficit spending: the costs and benefits depend on what you are financing, ongoing operations or long-term infrastructure. But no one seems to know or care.

That kind of thinking, moreover, frames the debate on everything else. During the last presidential election, when it appeared we might actually have some temporary budget surplus lying around, we heard hundreds of proposals for how to spend the money — almost all of them by making permanent commitments to entitlement programs rather than one-time commitments to capital improvements. To someone who has to manage cash flow and capital needs for either a family or a business, using a finite reserve fund as a down-payment on permanent spending commitments seems ludicrous; in an environment where there is no distinction between operations and infrastructure, it seems routine.

Many states, including my temporary (and blessedly former) home of California, have had the same problem. In the case of California, they built increases in spending for education and social welfare programs upon large capital gains revenues from the dot-com boom. When the capital gains, and therefore the revenue generated by them, predictably went away in the bust, the state was left with spending commitments that were politically impossible to roll back but with no revenue to support them.

It would seem that sparking a broad discussion about such distinctions — about recognizing the difference between short-term expenditures and long-term commitments, and about recognizing the difference between short-term peaks and long-term trends in revenues — would be a benefit to everyone. Perhaps you are the one to do so.

Thank you for your attention.

© Copyright 2003, 2005, Augustus P. Lowell

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