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Backgrounder #911

August 14, 1992

Lessons from Business on Cutting Federal Spending


(Archived document, may contain errors)

August 14 1992 LESSONS FROM BUSINESS ON C-G FEDERAL' SPENDING INTRODUCTION j Ntialy .two years ,after President George.Bushmd the.U.S, Congress struck the 1990 budget'deal that pmmisd to.put"America's$scal ,h&se h.arder, both .the federal def&it..yd f ederd spending 'are' higher thh at agy time in the counay's tiny La une':s feat in the House of Represenutives..of :aconstitution

amendmen6which would have-required a balanckd federal..budget L by fisca'J998 &monstrates the contin uing;.*abi.lit$;of 2 Wa shington to &me :p grips Gth the'tountq?s fiscal pmblems.'Con gresj 'seems pqalyqd-hableto'fashion a'htrategy to bring.s$nding under .I control r. Lawmakers would be wise ,to exam~e the steps American..bus

esses.take when e nomic'conditions .I force .duct ionsin a fm's operating costs: The.techniques used by business..ownep..to tighten .their: belts offer many lessons for Congress.,That is why,so m.Gy.:voprs haq.e been calling .for:Washington to apply .a business-pe appach.$;ex itr&t ththe.coun~,.from.the, f ederal L. budget 1 quagmire Overwhelming Budget; Most newly elected members of the 103rd Conyyss. will lie:stunned when:they,&ve in Washington2ind discov&what they have inheri'kd-a tal 1993 budget;deficit now,projected~~at$336 billion hd axinual deficits t hrough ei endiof,,the decade estimated at over $200 .billion; according to the Congressional-B,udi get:Office (CBO Even the most refbrm&iinded ladaker. could be oyerwhelqd, bxi j the sheer magnitude of the.feder.al budget&a document, ove62;200' pages long , rep is.en

g nearrp 5 trillionin,annual expenditures:or mog.than 25 percent of I 1n.order avoidthe.same paralysis. suffered by the.cmnt Congress, members of the xt.;Congress should put themselves in the place.'of a business owh&.trying to save his .enterp rise'from bhptcy court. To get the government back the black, Con Fss.and the,Pqgident should consider.the same questions I a smart business oWx j I L AJr?erica:'s~~ss;~omestic product (GDP I asks,$hen he:isui against.the wall L Question I;:JWhat,can I re alistically expect my annual income to be during 2 I the.next.few yew Question #2: How can I get my expenses below my expected income?

The importance of establishing realistic income or revenue estimates cannot beover tad. Lagging revenues often lead many business owners unwisely to increase their nices. They suppose that the higher prices will be paid by the same number of custom IS and so produce more income. But more often than not, higher prices drive custom IS away, leading to less income-not more. Th i s lesson has yet to be learned by Washingtons politicians. Raising taxes slows economic growth and usually leads to ower than expectedrevenues. And=sorting.to.tax inmases, like raising prices, usu Uy means putting off the tough but necessary steps to curb costs Like wise business ownen, therefore, policy makers must come to grips with run iway spending. To do this, Congress should adopt the steps routinely taken by embat led fums to cut costs. Among them Cut overhead, travel, and personnel costs.

Example: Congress should freeze overhead costs far two years, then cap future growth to the inflation rate Bypass the middle man by finding cheaper ways to purchase goods and services without reducing the quality of the service.

Example: Congress should give poor people housing vouchers to help pay rent on a home of their choice rather than fund the construction of new public housing Cease unprofitable activities.

Example: Congress should eliminate the Federal Crop Insurance Program Close outmoded or Inefficient departments.

Example: Congress should close the Federal Helium Reserves and Excell helium processing plant Streamline departments and agencies by ellmlnatlng duplication and merging departments with similar goals.

Example: Congress should merge sixty federal environmental programs into a single block grant to the states Eliminate waste by trimming luxuries, perks, and unnecessary spending.

Example: Congress should eliminate the honey, wool, and mohair farm subsidy programs Sell assets to generate cash and eliminate future costs.

Example: Congress should sell to the private sector the governments 205 billion direct loan portfolio 2 I 8) Give managers the flexibility to cut wasteful spending.

Example Congress should repeal the 1931 Davis-Bacon Act that raises costs on federal construction contracts 9) Crack down on deadbeats.

Example Congress should allow the Fanners Home Administration to foreclose on delinquent loans and hire private collection agencies IO) Contract out to private providers for functions currently done in house that can be done cheaper by outside firms.

Example: Congress should privatize NOAAs research fleet.

Using these and other commonsense business measms, lawmakers can balance the federal budget by fiscal 1998 without raising new taxes, without inflicting deeper de fense cuts than those already proposed by the Bush Administration, and without reduc ing benefits in maj o r entitlement programs WHY COST-CUTTING IS NEEDED The chronic inability of Washington to put the countrys fiscal house in order has led many taxpayers to ask, Why not apply the same sound business practices to gov ernment that entrepreneurs apply to their businesses or that each household must apply to the family budget?

To be sure, the federal government and businesses are different in many fundamen tal respects. Most important, of course, is the fact that businesses cannot print more money or confiscate their customers money to cover their debts, as can the govern ment. In addition, the governments revenue, unlike business income, is not directly connected with perfmance or service. If a business routinely wastes money on perks for management or unpopula r product lines, when those dollars should be invested in new equipment or new product design, the business soon will be forced to close its doors. When the government wastes money and manages its programs badly, it runs a deficit and raises taxes.

In rece nt years, however, it has become clear that, despite the obvious differences the government is subject to forces very similar to those experienced by every private business. A business that raises its prices too high, for instance, loses customers and in come. Similarly, a government that raises taxes too high slows down the economy punishes private productive efforts, and thus also sees its income lag or even decline.

Keeping Costs Below Revenues. The smart business owner begins the process of putting his enterprise on a sound financial footing by estimating his future stream of revenues and then making sure his costs do not exceed that level of income. He does not begin by projecting how much his costs are likely to be and then figure out how to make eno ugh money to support that level of spending. Yet this is precisely how Wash ington goes about budgeting.

Reduced to their basic elements, deficits result from too much government spending rather than from a lack of tax revenues. For instance, the Congressi onal Budget Office estimates that federal tax revenues will grow by mm than $400 billion over the next 3 ive years, from $1.088 trillion in fiscal 1992 to $1.49 trillion in fiscal 1997.To most axpayers this revenue pwth, which averages 6.5 percent annuall y, would seem mOre han sufficient to fund federal priorities and lower the deficit without tax increases. Yet he chorus in Congress is that tax hikes are needed for deficit reduction.

In addition to the extent that any lawmakers are seeking to get the defi cit under con rol, the emphasis is on after-the-fact sweeping cuts when deficit targets are missed ather than prudent cost controls to achieve deficit reduction. This is like a business xomising its stockholders that it will slash spending across the bod in profitable as well as unprofitable lines to end losses, rather than overhauling its operations to get osts under control.

The deficit reduction plans of two lawmakers, House Budget Committee Chairman Leon Panetta, the California Democrat, and Senator Ph il Gramm, the Texas Republi an, exemplify this approach. Both plans set targets for future deficits and erect elabo rate budget rules to trim a deficit if it exceeds the level established in law. In this sense, each plan bomws the notion of a sequester-th a t is, automatic deficit reduction measures-that originated with the 1985 Gramm-Rudman-Hollings law. Under Panettas sequester plan, a mix of spending cuts and tax increases would be used to close the gap between the deficit target and a deficit overrun. Gr amms sequester plan requires across-the-board spending cuts, with certain exceptions for programs such as Social Security, to lower an excessive deficit to the level prescribed in law.

Blunt Instrument. While these plans do take serious action to cut spend ing with the blunt instrument of a sequester after spending has overrun, neither seeks to introduce prudent cost-cutting measures to make sure the targets are achieved in advance. This is like waiting to lock up an alcoholic after he has been arrested for being drunk and dis orderly, rather than getting the alcoholic into a treatment program to help him avoid ar rest.

Thus, a sound deficit reduction plan should introduce steps to prevent Washington from hiking spending before overspending exacerbates the defxit. The simplest and most effective way to do this is by placing caps on the growth of futm federal spend ing. T h is approach avoids the need for complex rules and formulas. It would legally re quire Congress to make economies before programs are appropriated, rather than slash ing spending or hiking taxes after the total spending on programs has pushed up the 4 defi c it. The spending caps should be fixed at a level that is effectively the sum of the targeted deficit level plus the expected amount of revenues For instance, the spending caps needed to meet Panetta's deficit reduction plan would be as follows Table 2 Cal c ulating Federal Spending Limits Billions .of Current Dollars 1993 1994 1995 1996 1997 1998 II CBO Projected Revenues Panetta Deficit Targets 1 ,I 73 $1,262 $1,340 $1,413 $1,490 $1,578 336 232 127 55 38 0 Note: The Fiscal 1993 budget is nearing completion i n Congress, meaning serious deficit reduction will have to be initiated in fiscal 1994, which begins October 1,1993 As is shown in the following table, these new spending levels 8~e considerably lower than. the levels currently projected by the Congressio n al Budget Office. This means that mm than $708 billion must be trimmed from this projected rate of spend ing growth Table 3 Calculating the Required Spending Cuts Billions of Current Dollars CBO Projected Spending Levels New Spending Limits I 1993 1994 19 9 5 1996 1997 1998 1,510 $1,529 $1,543 $1,602 $1,726 $1,843 1,510 1,494 1,467 1,468 1,528 1,578 5 WHY TAX HIKES DON'T CUT DEFICITS The typical lawmaker, like the typical business owner, at first is likely to blanch at the prospect of trimming substantial am o unts of spending hm the budget-ven if the cuts with the federal budget. The temptation, of corn, is to try to increase income to avoid painful cuts in spending. Yet as business owners well know, raising prices to improve the bottom line is risky. Price hi k es often drive customers away, thereby lowering rather than raising; future earnings ton has raised taxes 54 times in an effort to achieve deficit reduction, yet it has bal anced the federal budget only once, in fiscal 1969 The most recent major tax rate in crease, the 1990 budget agreement raised" taxes by some $175 billion during fiscal years 1991 through 19

95. The problem is that the projected new revenues have not ma terialized. In July 1990, the Ofice of Management and Budget estimated that Washing ton would collect a total of $6.4 trillion in revenues between fiscal 1991 and 1995.

Two years later, in July 1992, OMB estimated $5.87 trillion will be collected during this period-$529 billion below the earlier projection. When this loss of revenues is c ombined with the budget agreement's putative $175 billion tax hike, the total emr is over $700 billion.

The reason: Tax increases rarely bring in the amount of revenues projected by the tax estimators at the Congressional Budget Office or the Office of Ma nagement and Budget. Like the short-sighted business owner who imagines every price increase means more earnings, these tax experts mistakenly assume that increasing taxes will have no effect on taxpayer behavior. In the dynamic business economy, customer s eas ily can substitute goods of better value for higher-priced items. Increases in taxes also encourage taxpayers to put their money into lower-taxed activities, meaning the gov ernment rarely collects as much revenue as tax-raisers project merely reduct i ons of a projected rate of spending growth, as is the case This lesson has yet to be learned by Washington. Over the past thirty years, Washing A BUSINESS-LIKE APPROACH TO CUTTING SPENDING Faced with bankruptcy, the smart business owner must scour every a s pect of his op eration in a no-nonsense manner. There axt many steps business owners routinely take to reduce costs. Congressional lawmakers should adopt at least ten costcutting prac tices from the business world 1) Cut overhead, travel, and personnel co sts.

The first step taken by many struggling businesses is to cut overhead expenses and travel budgets, and perhaps even freeze new hiring and employee salaries. These are cuts in "fixed" costs of doing business. Overhead expenses include such things as re nt 1 Senam Robert W. Kasten. Jr A Balanced Budget Amendment That Won't Tax America Henrage Lecrure No 3

86. June 2.1992 6 utilities, equipment purchases, and physical plant improvements. A dollar spent need lessly on these items is a dollar taken directly from the bottom line.

Since the recession began in 1990, most U.S. companies have taken steps to trim fixed costs and to freeze or reduce employment. Yet the federal government has in creased funding in these areas in recent years. Nearly.24 cents of eve ry tax dollar spent on domestic programs (excluding the Postal Senrice or some $208 billion, currently pays for the overhead expenses of federal civilian agencies. The government also has ian employee wages and benefits,-again excludingthe semi-independen t Postal Ser vice. And since 1989, the number of federal employees actually has grown by over 63,000, from 1.107 million to 1.17 million. Cutting overhead costs will save billions without lowering the quality of services.

Example: Fmzing federal civilian a gency overhead expenses for two years, and capping the future growth of these costs at the inflation rate could save some $137 billion over five years I done little to hold down hiring levels. More than $100 billion per year is spent on civil- I I Example : Freezing for one year the total level of federal civilian employee compensation, excluding benefits, could save $24 billion over five years I 2) Bypass the middleman.

When costs must be cut, businesses often avoid buying their supplies from distribu tors , preferring to purchase them directly from the manufacturer. Successful compa nies such as the Wal-Mart Corporation, for instance, bypass the traditional middlemen or distributors and buy directly from the manufacturers. This policy improves the man agem ent of inventory in addition to reducing costs to the customer. Yet in every fed eral program there is an anny of middlemen between theTreasury door and the in tended beneficiaries of the program.

Example: The federal government spends about $18 billion ea ch year on housing for the poor. But most of this money ends up in the pockets of middlemen, including high-priced and well-connected contractors, social service groups, and officials of local public housing authorities. The public housing program is gros s ly mismanaged and wasteful, and fails to meet the needs of the poar. And although about 100,000 of the nations 1.4 million public housing units currently m vacant, the federal government still disburses operating subsidies for these vacant units to local housing authorities.

A more compassionate, and cost effective, method of housing the poor would be to cut out the middlemen and give poor families a housing voucher, letting them use it to help pay the rent in an existing apartment of their choice. Since u sing vouchers can house the same number families for half the cost of new construction, the government could save billions of dollars while giving poor people the freedom and mobility en joyed by other Americans 7 I 3) Cease unprofitable activities When f a cing economic difficulties, many companies take prompt action to close down unprofitable product lines, especially if that line shows little promise of ever breaking even. For instance, General Motors Corporation currently is giving serious thought to cea s ing production of the Chevrolet Caprice automobile, after spending sev eral years trying to improve slumping sales? General Mom cannot afford to let nos talgia for the model name cloud its judgment The federal government, by contrast, almost never cuts mo n ey-losing programs, re gardless of how much money has been poured into them or how badly they have failed to meet their goals Example: Intended to encourage farmers to protect themselves bm financial losses due to natural disasters, the Federal Crop Insur a nce Corporation FCIC) has not been actuarially sound for many years. The government has spent hundreds of millions trying to prop it up. The reason the program is failing is that farmers actually have no reason to purchase crop insurance because they know from experience they can count on Congress for emergency disaster assistance if there is a crop failm. According to the Congressional Budget Office, between crop years 1981 and 1989, the federal government paid $6.0 billion for ad hoc disaster assistance The program should be terminated with the understanding that Congress is vested with the authority to fund disaster assistance when it is necessary. This measure could save taxpayers some 2.8 billion over five years I 4) Close outmoded departments.

Busines ses routinely eliminate outmoded offices, divisions, or equipment that no longer serve their needs. For instance, few delivery companies would continue to pay for the maintenance and high upkeep costs of a 1960s delivery truck in the 1990s. And no prudent cash-strapped company would continue funding for departments and pro jects long after their purpose had been accomplished. Yet the federal government cur rently administers dozens of obsolete programs that are the legacy of public needs from before World War II.

Example: The Rural Electrification Administration (REA was established in 1931 to finance the electrification of rural America. Nearly 100 percent of rural America has electric service and nearly 98 percent has telephone service, and so the program is no longer needed. Yet it still exists and continues to drain money from taxpayers pockets today.

Example: The National Helium Reserves and the Excell helium processing plant were created in 1929 to insure a constant supply of helium for the blimps then deemed to be important for Americas national defense. Today, of course, blimps do not play a part in the Pentagons high technology defense system, and there is a strong private sector 2 Warren Bro w n and Frank Swoboda, GM Misses Mark with Bulky Caprice, The Warhingron Posr, July 6,1992 8 helium industry. Still, the program continues to exist, consuming over 120 million in taxpayer funds each year Example: The National Fertilizer Development Center g r ew out of a munitions plant at the end of World War I. Later the fertilizer factory was turned over to theTennesseeValley Authority. For some sixty years the govemment-owned plant has produced fertilizer and conducted fertilizer research for the benefit o f private companies. It cmtly costs taxpayers over $35 million per year to operate the facility 5) Streamline departments.

An efficient company uses the minimum number of employees and departments to accomplish the maximum amount of work. Except in very cr itical areas, duplication and redundant capacity is considered wasteful and costly. Yet the government main tains overlapping programs and agencies on a huge scale.

Example: The federal government manages over 75 diffemnt poverty programs. The annual cost of these programs to all levels of government totals some $250 billion-nearly two and one-half times the cash needed to lift every poor American above the poverty threshold.

Example: Them axe over sixty federal environmental programs. Some 6 billion could be saved over five years simply by merging these programs into a single block grant to the states.

Example: The Department of Agriculture manages 11,OOO field offices in 94 percent of the counties in America, even though only 13 percent of the nations counties are considered agricultural.

Example: Them axe at least 37 programs, located in at least three agencies, designed to manage fishery issues Eliminate waste.

When the economy is strong and business is booming, many firms rn willing to spend money o n activities or expenses not directly related to the mission of the com pany. These might include executive perks such as company cars and country club memberships. But during hard times, owners usually act quickly to cut back perks and costs not directly related to the central business of the fm.

The federal government, on the other hand, spends tens, if not hundreds, of billions of dollars on programs and activities that do not benefit the country as a whole and are not related to the central purposes of government. MOE often than not, this spending helps no one, save perhaps the bureaucrats who collect or spend the money and the spe cial interests who receive the government largesse. There thousands of these spe cial projects, often called pork barrel p rojects, laced throughout the federal budget.

Table 4 lists just a few such projects slated for funding in the fiscal 1993 appropria tions bills recently passed by the House of Representatives 9 Wasteful spending, however 3ften extends beyond the tradi tio nal pork projects Example: The government has established dozens of commissions of questionable national purpose. Among them The American Battle Monuments Commission; the Commission for the Preservation of Americas Heritage Abroad; the Chris topher Columb us Quincentenary Jubilee Commission; the Delaware River Basin Commission; and the Franklin Delano Roosevelt Memorial Commission.

Terminating most of these commissions could save taxpayers some 645 million over the next five years Example: The honey, wool a nd mohair subsidy pgrams have been called the dinosaurs of federal programs by the General Accounting office because they should have been terminated yean ago. These programsarefederaperhthat benefit only a very small group of individuals, yet cost taxpay e rs some 200 million annually 7) Sell surplus assets Even the most efficient businesses, burdened by heavy debt or expenses, may find it necessary to turn some assets into cash. For instance, airlines sell routes, conglomer ates sell divisions real estate companies sell land, and publicly held companies sell more stock.

The federal government, however, is prohibited by its own arcane budget laws from reducing the deficit by selling assets.The 1990 budget agxeement, for instance, insti tuted rules that preve nt Congress and the Administration from using funds raised from 10 the sale of government assets for deficit reduction. This is like a bank telling a family it must foreclose on their farm because the bank cannot count as a mortgage payment *e money the f amily has just deposited from a stock sale.

In an era when governments from Moscow to Mexico City are transferring their as sets to the private sector, it is ironic that the U.S. Congress discourages or prohibits the federal government from selling assets to reduce the deficit There many assets that the federal government could sell to reduce the deficit Example: The government currentlyholds some $205 billion worth of outstanding direct loans. These loans should be sold to the secondary loan market in muc h the same manner that a mortgage company resells its loans. The Farmers Home Administration (FmHA) raised nearly $4 billion for the Treasury in 1987, the last year in which the agency was legally allowed to sell its loans to the private sector.

Example: T he government currently manages enterprises worth billions of dollars that should be sold to the private sector. These include the Naval Petroleum Reserves, the Power Marketing Administrations, the Tennessee Valley Authority, and millions of acres of publ ic lands 8) Give managers flexibility to cut wasteful spending.

Line staff and managers often are better able than their superiors to identify cost-re duction measures in a fm. Thus wise business owners encourage junior managers to look for ways to save the company money.

It is hard to imagine any company being so foo lish as to institute company rules to stop their managers from saving money. Yet Congress does exactly that. For instance Congress regularly sets lower limits on the number of employees that must staff cer tain agencies. These employment floors, as they a re known, prevent agency manag ers from making the most effective use of the employees they supervise, such as by shifting workers from one department to another. Other rules similarly prevent manag ers from saving money.

Example: The U.S. Park Service is prohibited from covering its costs by raising the entrance fees it charges to visitors. Because of this rule, the Park Service now charges tourists less than one-fourth of the real costs associated with admitting each Visitor. The Service spends $220 mill ion per year on visitor services, but receives only $60 million back through fees.

Example: The Davis-Bacon Act of 1931 increases the costs of government construction contracts by over $1 billion annually. It does so by forcing contractors to pay union sca le wages on all federally funded construction contracts, even though less expensive labor often is available. This legislation originally was enacted to keep black workers off federal construction sites. That is precisely what it has done during the last sixty years. A similar law, the Service Contract Act, serves the same function for federally funded service contracts. The extra costs imposed by these laws: some $2.0 billion per year I 11 9) Crack down on deadbeats.

No automobile company with.a financing department would survive long if it al lowed customers to miss payments without penalties or to default on their loans with Dut facing foreclosure. Yet the federal government loses billions each year on its loan programs and yet does little to deal with defaults.

Example: The Farmers Home Administration (FmHA) wrote off some 8.5 billion in loan losses in the past three years. One reason it did so is that Congress prohibits the FmHA from cracking down on bad debtors or from hiring private collection firms tocollect on delinquent loans. In many cases, new loans are given to known poor credit risks.

Example: The government spends about $3 billion per year subsidizing Stafford Student Loans. Of this amount, roughly 30 percent, or some $1 billion, is dedicated to guaranteeing payments to lenders on defaulted loans. Measures that would reduce these defaults include: Eliminating all federal interest rate subsidies extended to students after they leave school reducing interest rate subsidies to banks by one perce ntage point; and requiring educational institutions to share in the risk associated with their students defaulting on federal loans 10) Contract out functions.

Few businesses use in-house staff to perform every support function required to keep a business running. Most find it more efficient to contract with other firms to per form at least some specialized functions such as accounting services, automated data processing (ADP) seMces, garbage collection, legal work, and office cleaning. A busi ness facing bankruptcy is especially vigilant in searching to see if any of its overhead activities can be carried out less expensively by an outside firm.

Yet Congress has made it illegal in some cases for government agencies to contract out or privatize certain acti vities. Thm are currently over 75 laws on the books pre venting government agencies from privatizing various functions now being done by higher-cost government employees. Some laws prevent agencies from even studying the possibility of contracting out. Bu t turning many government functions over to the private sector could save taxpayers billions of dollars each year.

Example: The National Oceanic and Atmospheric Administration NOAA) currently operates its own fleet of research vessels. The General Accounti ng Office has recommended that the fleet be privatized over a five-year period. GAO has criticized the government-run fleet for being too expensive to maintain and operate. As much as $50 million per year could be saved if NOAA could contract with private fms CONCLUSION Unlike American businesses and households, Washington lawmakers and officials do not risk an appearance in bankruptcy court if they fail to balance their books. In fact, they face few if any penalties far running up huge losses, and can alw a ys turn to American businesses and households to foot the bill. But taxpayers are growing tired of Washingtons failure to institute sensible cost-cutting measures 12 If Washington will not place itself under the xestraint of a balanced budget amend nent, t he least lawmakers can do is to approach the deficit problem like a business wner trying to save his company from Chapter 11 bankruptcy.The smart business mner, realizing that increasing prices is not a way to increase mipts, knows that what he must do is find ways to hold spending well below anticipated future income Smart Business Strategy. In order to bring down spending, the desperate business wner knows he must eliminate any spending that does not dhctly advance the pri nary goals of the company. Amon g other things, this means trimming overhead costs utting wasteful andunnecessary exgenses,dosing-obsdete product lines, and finding heaper ways of getting a better product to the consumer.

Newly elected lawmakers coming to Washington after the November el ection will be like new managers taking over a failing business and facing angry stockholders Business as usual will mean out-ofcontrol spending and huge deficits. As household xs and business owners, these men and women know what the private sector does to Let costs under control. They should take the same approach to federal spending once they are sworn into office Scott A. Hodge Grover M. Hennann Fellow in Federal Budgetary Affairs 13

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