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How the government cooks the books; the budget deficit is bigger than you think.


In October, 1908, a landmark exhibit opened in a private gallery on lower Broadway in New York. According to the show's ebullient sponsors, 62,808 attended. "Pictures that Tell Stories of a City's Waste' was the draw. Everyone came to see the budget of the City of New York.

Even The New York Times was excited. "The idea of the exhibition is to show with striking tables and in graphic form what the city is doing, what it needs to so, and how it is day by day wasting a large part of its income,' it reported.

It was the Progressive movement at its peak, and literally millions of Americans--not just a few green eye-shade types--wanted to see what was in their public budgets. Two years later, another exhibit of New York's budget, blown up and pasted on boards drew a million spectators wanting to know where their tax dollars were going. "No voter, certainly no householder or housewife, can merely stroll through this exposition without receiving a certain understanding of the kind of men who ought to be selected to attend to the several branches of such an immense concern,' the Times opined. Held over by popular demand, the exhibit soon inspired similar displays throughout the country, fueling a genuinely popular movement.

We could stand to rekindle some of that curiosity. Today we debate the deficit ad nauseam, but we are evading a fundamental problem. The number we identify as the deficit--the $200 billion-ish figure we hear-- includes only a fraction of our actual debt. The additional debts will eventually come due. For instance, the government has promised to pay out trillions of dollars in Social Security payments, but none of that accumulating debt shows up in each year's budget deficit. Similarly, big Pentagon costs such as military pensions and weapons systems will cost us later, even if they aren't on this year's books. Rather than pay some of these costs now, Congress (and many states) impose these obligations on future taxpayers, hoping that somehow, the money will be there. We don't have to stand in line to see the budget. But we do need to see it clearly.

Bomb throwers

To really understand the budget, you have to understand the accounting on which it is based. Accounting is supposed to give an accurate and useful description of how an institution is taking in money and spending it. Its usefulness depends on the kind of questions one wants answered. If the questions are short-term--"How much money do we have now?,' "How much will we have at the end of the year?'--then the calculations are fairly straightforward. Just keep track of the cash-flow.

Back when the federal government did little more than guard the coasts and deliver the mail, annual cash-flow accounting could provide an adequate picture. But the expansion of government services has created a series of long term obligations extending years, even decades. Each day, entitlement programs, such as Social Security and Medicare, obligate the government to pay benefits far into the future, as workers build up claims by paying into them. Indeed, since the end of World War II, nearly all the growth in federal spending as a percentage of GNP, excluding interest costs, has been in programs that promise to pay future benefits. Today's budgets create tomorrow's liabilities.

So what about next year? What about ten or 20 years from now? To answer the fundamental question of whether an institution is living beyond its means, one has to know how fast capital assets are likely to wear out, what it will cost to replace them, and what big contracts will come due. For this reason, the federal government requires all publicly held companies to disclose their finances using an "accrual' basis rather than simply counting up annual receipts and expenses. For the same reason, 25 states use accrual systems, and ten are converting to them.

It makes sense. Under accrual accounting, liabilities are reported as they are accumulated, rather than when they are paid off. Of course, those big liabilities can be paid off over a period of years. So accountants using the accrual method take that into consideration by calculating how much should be set aside each year to help pay off those long-term expenditures. It's still bean counting, but it's bean counting with vision.

Governments that don't use accrual accounting can find themselves swamped by debt. During the first half of the seventies, the City of New York used simple cash-flow accounting to keep its books and each year proudly reported a balanced budget. Actually, it was slouching towards bankruptcy. For years, the city had been accruing enormous long-term liabilities--especially public-employee pensions--that went unreported in its annual budget. In 1961, 25 percent of the money the city collected from taxes was paid out to retired city workers. By 1975, that figure had jumped to 40 percent. Even when the comptroller's office did make projections about future retirement benefits, it did so using life and disability tables developed near the turn of the century--when a cop was unlikely to live two decades in retirement.

The rest is a familiar story. By 1975, the city was broke. Wary bankers denied the city further credit, forcing it to do beg the Ford administration for relief. Eventually the feds came through with $4.5 billion in federal loan guarantees. But there was a little-known twist. The federal government agreed to the bailout only if New York switched to accrual accounting.

Nothing could have been more hypocritical. The much-heralded, nonpartisan, professional Congressional Budget Office still tallies up the federal budget on a year-to-year basis, just like New York City did. So does the Office of Management and Budget, controlled by the White House. Last year's $220.7 billion deficit was a measure of annual losses, of how much red ink was spilled during the time it takes the earth to revolve around the sun. That's an important number to know, of course. The more money the government borrows in any given year the less there is available for consumers and industry. But the deficit figure--bandied about by columnists and congressmen trying to prove a point--is ultimately misleading, because it ignores the liabilities accrued, but not yet due. Like New York City in the seventies, the federal government is kidding itself.

So how big are the deficits? You'd better sit down. In 1975, Arthur Andersen & Co., one of the country's "Big-8' accounting firms, developed a consolidated financial statement for the U.S. government using accrual accounting and other generally accepted accounting principles. It looked at things such as the pensions we've promised and weapons systems commitments. It found that the accrual-basis deficit for the previous year was more than $95 billion. The government had admitted to a deficit of only $6.1 billion.

Needless to say, the hemorrhaging has gotten worse under Reagan. In 1984 the government declared a deficit of $185.3 billion, but Andersen found it to be $333.4 billion. To eliminate that deficit would have required a 113 percent increase in individual taxes--assuming that such an increase did not itself cause a recession or depression.

Not everyone has ignored the problem. One hotbed of reformist accounting is the Government Accounting Standards Board (GASB). Financed by public accounting firms, the municipal securities industry, plus state and local governments, GASB was founded in 1984 after years of what its chairman, James F. Antonio, characterizes as "smoke, fire, and brimstone.' GASB's mission is to set what are known as "generally accepted accounting principles' for public entities.

It's hard to picture accountants as bomb-throwers, but the GASB manifesto, which includes a call for accrual accounting, could have radical implications for the federal government. Were the federal government to adopt GASB's rules, it would have to report that its real deficits are roughly $150 billion larger than it now admits.

Backdoor borrowing

Which programs account for the difference between the budget deficit Arthur Andersen found and the one we've all read about? GASB officials say the biggest culprit is unfunded pension liabilities, the commitment we've made to today's public employees about the money they will receive upon retirement. It's a cost we incur today, but, under the current system of accounting, don't start paying until tomorrow. "With public employee pensions, you get the full benefit of an employee's service this year. But the full cost of that service doesn't come due for many years into the future,' said Antonio.

Pensions used to be a far simpler matter than they are today. In 1818, Congress established its first federal employee pension program: a meanstested plan for Revolutionary War veterans. Today the federal government operates 38 separate retirement programs for its employees and their dependents. Most of these programs are very small, ranging from accounts for former presidents and their widows to the National Oceanic and Atmospheric Administration Corps Retirement system. The majority of federal workers, however, are covered by two giant programs, the Civil Service Retirement System (CSRS) and the Military Retirement System (MRS).

Federal workers, except those at the top levels of management, earn as much or more than their counterparts in the private sector, and have higher pensions as well. Civil servants hired before 1983, for example, may retire at age 55, after 30 years of service, with an annual pension equal to 56 percent of their average salary during their peak three years of earnings. Virtually no private sector plan replaces such a high percentage of a retiree's previous salary. Of the 50 largest plans offered by Fortune 500 companies in 1983, none offered replacement ratios of more than 44 percent.

Civil servants don't finance these benefits themselves. Civilian employees set aside 7 percent of their salary for their retirement. But that only covers 12 percent of the system's current costs, let alone the costs of future pensions. The rest comes out of general revenues.

All totaled, the commitments made to federal employees are staggering, despite recent legislation reducing military pensions for those who have yet to enlist. The pensions of those who are currently in uniform will cost $444.3 billion, according to the Treasury Department. The liabilities of the civilian CSRS pension fund are even larger--$537 billion as of September 1985.

The government doesn't have to pay all those pensions at once, of course. The cost is spread over years as civil servants retire. Yet because of the way the government keeps its books, these huge liabilities totaling several hundred billion dollars are not even acknowledged in each year's solemn announcement of the budget deficit, nor are they counted as part of the national debt. If the federal government followed the practice of private pension plans by amortizing these liabilities over a 40-year period (that is, pre-paying them in yearly installments) the cost would come to roughly 85 percent of each year's payroll, or approximately $43 billion, according to the Grace Commission.

By not amortizing these pensions now, we put off the hard choices--leaving them to future taxpayers who may be forced to choose between paying the retirement benefits for someone who worked on Atoms for Peace or building a new space program. The least we could do is to admit to this backdoor borrowing.

Pork without the smell

Underfunded pensions aren't unique to the federal government. Many states have also put off pension funding. While columnists such as David Broder have written about vibrant, well-managed state governments, the truth is that they, too, are encumbered with enormous pension debt. More than five thousand separate state and local pension plans cover nearly 12 million public employees. Estimates of their unfunded liabilities are difficult to come by, since different jurisdictions use different accounting methods and assumptions. But a recent study by Robert Inman, published by the National Bureau for Economic Research, found that the unfunded liabilities of teachers' pensions amounted to more than $400 billion in 1980. That liability rose 250 percent during the seventies.

The unfunded liabilities of public employee pension systems are a "quiet' crisis, which makes them all the more dangerous. Any government can borrow from the future by underfunding its pension programs without having to admit how high the deficits are. The same is true of state and local government. Unlike when the government sells bonds, under-funding today doesn't crowd out private borrowers or raise interest rates. All the pain comes later.

That's why no constituency is storming the state house in Sacramento or Baton Rouge, demanding that the pensions of the 1990s be reined in. If anything, politicians have learned to love big pensions--seeing them as an easy way to help their public-employee constituents without being accused of being big spenders. (Even a small state like West Virginia has amassed $1.5 billion in unfunded pension liabilities for its teachers.) It's pork barreling without the stigma.

That's true even in states that have a reputation for fiscal responsibility. In California, for example, the constitution states that any bond issue more than $300,000 must go to the voters for a referendum. Voters must be told when and by what means the principal and interest will be repaid. Even to get such a proposition on the ballot requires a two-thirds majority in the legislature. Another kind of debt--a pension, which can cost millions more--can be incurred without a vote by the taxpayers and with only a bare majority of the legislature. No current funds need be appropriated. In 1983, the state government passed "super safety' benefits for 10,000 state employees. The cost was $300 billion. The measure sped through the legislature and was signed into law in three days.

This kind of politicking has left the California State Teacher's Retirement System in deep trouble. Right now its cumulative deficit stands at more than $10 billion. Individual teachers contribute 8 percent of their salaries to the fund, and local districts match that amount. But that doesn't cover the cost. According to David Cox, a consultant to the California Assembly's Public Employee Committee, part of the problem is that when the fund was created in 1972, the contribution rate was intentionally set low to win political support for the program and "ease the shock' of its cost. Compounding the problem are the actuarial table writers who guessed wrong about how many teachers would opt for early retirement.

In Missouri last year, members of the legislature voted themselves and state workers a $13 million increase in retirement benefits. For a few veterans, such as the bill's sponsor, state senator Richard M. Webster, annual retirement benefits will exceed their current annual salary. State employees with 30 years experience can retire at age 55 with full benefits. The bill quickly cleared the Senate and the House will no debate.

The ruse can be worth it to politicians. They know it's important to keep public employees appeased. Nothing loses more votes than garbage or snow piling up on the street, or teachers, firemen, and policemen threatening to strike. For a congressman or senator, being on the wrong side of the federal bureaucracy can make it harder to help constituents cut through red tape, win grants, or recover lost Social Security checks or refunds from the IRS. A president who crosses the federal bureaucracy had better worry that his initiatives and executive orders will be quietly ignored or subverted. Then, of course, public employee unions make substantial contributions to candidates they like. The National Education Association doled out $2.9 million to congressional candidates during the 1985-86 election cycle; the National Association of Letter Carriers, $1.4 million. Since more than a quarter of the electorate is employed by the public sector, these unions command voting blocs no prudent candidate can ignore. Retired federal employees, by themselves, are a weighty constituency. In each of five states--California, Texas, Florida, New York, and Virginia--they and their beneficiaries totaled over 100,000 in October 1985. Nationally, they are 1.9 million strong.

Indecent exposure

Besides pensions, there are other costs we've pushed off until the future that don't show up in the annual budget deficit. Take insurance. The federal government is the nation's largest insurer, but it doesn't charge high enough premiums to cover the vast risks it has assumed. It insures loans to students, farmers, small businessmen, veterans, shipbuilders, home buyers, rural utilities. It insures bank depositors and the pension programs of 40 million Americans. These insurance programs expose future taxpayers to a total, contingent liability estimated by the Office of Management and Budget to exceed $3 trillion.

Are we going to have to pay all those policyholders? Barring a depression, probably not. But defaults on government-backed loans will place big pressures on an already tight federal budget, even if they won't necessarily bankrupt us. That's because Congress, unlike Mutual of Omaha, doesn't build up big reserves, enough to cover the benefits it is likely to pay out. Government insurance programs typically have no reserves or woefully insufficient ones. The GAO has lambasted the crop insurance program, pointing to annual losses of $100 million. The same is true of flood insurance, which has lost money every year for 20 years and has only crept into the black after a 200 percent increase in premiums.

Government isn't a business, of course. There are risks that the government should assume that private industry won't, like covering bank loans. But by undercharging today's beneficiaries, we put off costs until tomorrow. It's a form of borrowing that doesn't show up in the annual budget, but is still very real.

Consider the Maritime Administration, which was authorized in 1972 to guarantee loans to U.S. shipbuilders. Since then the fishing, maritime-freight, and off-shore drilling industries have been pummeled, making many of the ships the Administration helped underwrite unnecessary and unprofitable. Congress underfunded the program and now we're picking up the tab. Yearly defaults on this program alone, which were running less than $100 million through 1984, climbed to $1.4 billion last year.

Or take the Federal Savings and Loan Insurance Corporation (FSLIC), which insures the savings of thrift institution depositors. Between 1981 and 1986, as the government lifted regulations and left the thrifts free to make speculative investments, the number of insolvent thrifts increased from 16 to 445. Their misfortune is now ours. Over the past five years, the FSLIC's insurance fund has dwindled from a $6.3 billion surplus to a yawning deficit. The GAO estimates that the FSLIC will need at least $8 billion in new revenue just to cover near-term costs.

The Pension Benefit Guarantee Corporation (PBGC) is similarly underfunded. Founded in 1974, it stands behind private pension plans the way FSLIC stands behind thrifts. Most private pension plans still appear to be well-funded. But already--long before the enormous baby-boom generation reaches retirement age--we are seeing an increase in the number of plans in default. This year, the PBGC will take in $425 million and pay out $690 million.

That's not a huge difference, but it is likely to grow. The private pensions that the federal government insures--"defined-benefit plans'-- are legally required to have minimal reserves that are invested and making money. Yet the average private sector plan has assets equal to only 77 percent of its actual liability, according to a study by Richard Ippolito of the Labor Department. More than a third have funding below 50 percent. When these companies fail, the federal government assumes a retiree's pension up to $22,380 per year. In 1986, the bankrupt Wheeling-Pittsburgh steel company dumped $476 million of its pension liabilities on the PBGC. The recent collapse of the LTV Corporation added another $420 million. PBGC's long-term deficit is now $2.4 billion and growing. If Congress is to fulfill its promise to insure these pensions, it will have to put up more money.

"Too emotional'

When we talk about accounting, we're really talking about politics--the choices and sacrifices that we, as a society, have to make. Unfortunately, our current system of accounting brings out the worst in politicians of all stripes-- encouraging them to spend now and pay later. Under our current system, the Reagan administration has proposed selling land and other public assets, pointing to big revenue increases. This is absurdity. When we sell land, we're ignoring future revenues those assets could have produced. Liberals have their own way of cloaking tomorrow's bills. The annual budget for a favorite social program like the Small Business Administration hides the fact that many of those who receive SBA loans will default. Ultimately, the way we add up government spending is as political and as important as the spending itself.

It would be nice if there was one simple accounting technique that could clean up the government's books. But as pedestrian as accounting may seem, it is still a developing science. Just accounting for a single, relatively simple item, like highway maintenance, is a real intellectual challenge. When the government spends money to maintain a highway, the appropriation is entered in the books as a one-time expense for this year. Ideally, you would have an accounting method that could measure how a little money spend now on highways is actually saving a whole lot later on. But getting the books to reflect that is very difficult. While it's better than our current system, even accrual accounting has its flaws. Under accrual accounting, weapons are listed as assets--solid, worth a certain price--even if they are totally useless on the battlefield and have to be replaced. But federal funds to train America's next crop of electrical engineers go on the books as an expense, not an asset.

Yet even if there is no perfect accounting method, that doesn't mean we can't start asking the right questions. Throughout government, accountants are making pivotal decisions that demand scrutiny.

Last year the Treasury Department came up with a massive financial statement of the federal government's assets and liabilities. Buried in the document was an extraordinary political statement. The Social Security system's $4.647 trillion in unfunded liabilities were listed as "contingent' expenses, like banking insurance, that we may or may not have to pay. Fred Wolf of the General Accounting Office says that accounting for Social Security's unfunded liabilities is so politically charged that his office prefers not to take a position. "It's just too emotional,' he says. "Before we can get the accounting right, we need Congress to come right out and say what Social Security is. Is it a promise that can never be broken, or something else, like food stamps?'

We need a new budget debate. If these kinds of issues were up for discussion, there might be a little more outrage about our real debt-- whether it's caused by a pension increase or the sale of a revenue-producing piece of land. If the public understands a bit about the real debt it's running up, perhaps it will, like those curious New Yorkers at the turn of the century, pay attention to the writing on the wall.
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Author:Longman, Phillip
Publication:Washington Monthly
Date:Jul 1, 1987
Previous Article:The hospital without patients; a triumph of her majesty's civil service.
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