Budget Issues: Budgeting for Inflation in Civilian Agencies

Published by the Government Accountability Office on 1999-10-01.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Staff Study

October 1999
                 BUDGET ISSUES

                 Budgeting for Inflation
                 in Civilian Agencies


                   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.1 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

                    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.

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             aggregated to a relatively few account titles,2 (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

              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.

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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,3 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.4

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 Act5 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 2002.6 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.

 The National Defense Authorization Act for Fiscal Year 1987, Public Law 99-661, 100 Stat.
3980-81 (1986).
 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
 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).
 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.

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Budgeting for Inflation   Although DOD does not explicitly identify estimated inflation in its budget
                          request, its functional structure and large account titles enable it to apply
in the Department of      inflation factors to its accounts and to calculate the effect of any
Defense                   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

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                          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   Funding for inflation generally is not requested, funded, or tracked
                          separately in civilian agencies’ nonpersonnel, discretionary budget
in Civilian Agencies      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

                          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

                           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.

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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

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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.8 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.9 We believe this applies to civilian agencies as

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

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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.

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Page 9   GAO/AIMD-00-14 Budgeting for Inflation
Appendix I

Scope and Methodology                                                                        Appendx

             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.

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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,

(935320)   Leter   Page 11                                 GAO/AIMD-00-14 Budgeting for Inflation
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