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The Costs and Benefits of Retail Activities at Military Bases October 1997

The Department of Defense (DoD) provides a wide array of retail stores and consumer services at military bases for the benefit of current and retired military personnel and their dependents. DoD's retail operations have annual sales of $14 billion and employ some 96,000 civilian workers--one for every 15 active-duty personnel. Those operations include commissaries (stores similar to civilian supermarkets), which have annual sales of about $5 billion, and military exchanges, which have sales of about $9 billion. The exchanges operate retail stores similar to department stores and also furnish a host of other shops and services, including on-base gas stations, furniture stores, florist shops, optical shops, fast-food outlets, pet-grooming salons, and liquor stores. Based on annual sales, DoD operates the 10th largest supermarket chain and the 12th largest general retail chain in the nation.

Those retail enterprises have many supporters. For U.S. service members stationed overseas, commissaries and exchanges are sometimes the only affordable and accessible source of familiar products. For service members in the United States, DoD's policy of selling goods at below-market prices makes its stores an important noncash benefit. Military retirees generally view access to DoD stores as an entitlement earned through their years of service. Many military leaders see on-base commissaries and exchanges as integral parts of the military way of life and argue that they foster a sense of military community. Other supporters include store employees and the commercial vendors, brokers, and distributors that sustain the stores.

Despite the benefits that commissaries and exchanges provide, analysts concerned with reducing the size of DoD's infrastructure might question the rationale for the department's current retail system. That system--a large network of stores designed to serve families rather than to meet the needs of single troops--emerged during the early years of the Cold War. At that time, DoD's policy was that its retail activities were necessary to ensure that service members living at military bases had access to adequate, affordable shopping.

Today, the department no longer argues that it has to provide stores at military bases to make up for a lack of commercial alternatives. At least within the United States, DoD's role goes far beyond what is required to ensure convenient and affordable shopping for on-base communities. Commissaries and exchanges use below-market prices to attract active-duty personnel, retirees, and reservists who live off-base and might more conveniently shop elsewhere. Instead, DoD justifies its stores by arguing that the low prices they offer are a cost-effective alternative to providing additional cash compensation to service members.

This Congressional Budget Office (CBO) study finds that DoD's current justification is untenable: from a social perspective, government-run stores with below-market prices are not a cost-effective alternative to cash compensation. (If they were, it would suggest that society would be better off if the government provided stores for all of its employees, or even all of its citizens.) Instead, CBO finds that the military's role in retail activities has grown and persisted in part because many of the costs of those activities--including the cost of forgone taxes and return on capital--fall outside the federal budget. When DoD uses cash compensation to attract and retain a high-quality military force, the full cost of that policy appears in its budget. When the department uses retail stores with below-market prices, much of the cost falls outside its budget.

If DoD faced the full cost of its role in retail activities, it might well reassess and reduce that role. Designing policies to make DoD face that cost is not difficult. But such policies would entail difficult political decisions. Any meaningful debate over DoD's future retail activities may have to balance the inefficiency of subsidized, government-run stores as a way to attract and retain a high-quality force against the disrupted expectations and transition costs associated with changing that system.
 

An Overview of Commissaries and Exchanges

More than 300 commissaries, which are run by the Defense Commissary Agency (DeCA), operate at DoD bases throughout the world. Commissaries are like civilian supermarkets in many ways, although they differ in how they price merchandise and pay operating costs. Commissaries sell goods at a uniform 5 percent above the wholesale cost. DeCA relies on that 5 percent markup, or surcharge, to provide funds for capital investment. But federal appropriations pay for most of the stores' operating costs--including the salaries of DeCA's 18,000 employees, who are members of the civil service. Those differences from supermarkets ensure that commissaries offer below-market prices, making them a valuable benefit for both active-duty and retired military personnel. In 1995, commissaries sold over $5 billion in groceries (valued at the wholesale cost), collected almost $300 million in surcharges, and spent about $1 billion in appropriated funds.

Unlike commissaries, military exchanges are not part of a federal agency. Instead, DoD's three separate exchange systems--the Army and Air Force Exchange Service, the Navy Exchange Command, and the Marine Corps exchanges--operate as nonappropriated-fund (NAF) activities. NAF status means that the revenue exchanges receive from patrons is not part of the federal budget. It also means that exchanges are exempt from many of the laws governing federal personnel and procurement practices that limit the flexibility of commissary managers. (The exchanges' 78,000 employees are federal workers but are not members of the civil service.)

Although exchanges have nearly twice the annual sales of commissaries, they receive less public attention. The Congress appropriates almost $1 billion for commissaries each year, which ensures a continuing debate over the costs and benefits of those stores. Exchanges, by contrast, do not receive an appropriation specifically earmarked for their use. Instead, they actually appear to produce earnings for DoD. The average markup on items at exchanges (about 20 percent) generates enough sales receipts to cover the exchange systems' operating costs and still produce some NAF earnings. Those NAF earnings would disappear, however, if exchanges were required to reimburse DoD for the support services it provides with appropriated funds (such as exterior maintenance of exchange buildings and transportation of exchange goods overseas).

Even though the exchanges' ability to generate NAF earnings depends on the appropriated support that DoD provides, DoD can spend those earnings without a Congressional appropriation or authorization and without creating a federal budgetary outlay. Between 1980 and 1995, the three exchange systems produced $7 billion in NAF earnings for DoD. Roughly one-third of that was spent to finance new investment in exchanges; the rest went to support DoD's morale, welfare, and recreation (MWR) programs, such as libraries, fitness centers, golf courses, clubs, and hotels. Members of Congress have criticized some of the purchases DoD has made with NAF earnings (including a hotel at Walt Disney World and the construction of a third golf course at Andrews Air Force Base near Washington, D.C.). The department has responded by arguing that nonappropriated funds are service members' dollars rather than taxpayers' dollars.

Differences in the legal status, budgetary treatment, and pricing policies of commissaries and exchanges reflect their historical evolution. Although the modern commissary system did not develop until after World War II, it has roots in an earlier system in which commissary officers were responsible for issuing rations to troops and for managing cash sales of additional food items. Appropriated funds paid for operating the system and buying the goods that would be issued as rations; receipts from patrons paid for buying the goods that would be sold for cash. By contrast, the exchange system and many MWR programs had their roots in soldiers' canteens and other cooperative arrangements among service members. Although commanders provided in-kind support (such as access to buildings), the federal status of those NAF activities was only established over time through a series of court decisions.

Today, despite differences in their legal and budgetary status, commissaries and exchanges share many characteristics. They both offer below-market prices that attract patrons from off-base, and they serve similar populations (although reservists, who have unlimited access to exchanges, are limited to 12 commissary visits a year). DoD also offers similar justifications for the two systems. It justifies overseas stores--which account for 16 percent of commissary sales and 25 percent of exchange sales--in part on the grounds that they may be the only affordable source of U.S. goods. It justifies stores in the United States on the grounds that their below-market prices are a cost-effective alternative to cash compensation.
 

Subsidies for DoD's Retail Activities

DoD's argument for the cost-effectiveness of its retail activities is straightforward. Commissaries receive an annual appropriation of about $1 billion. Each year they sell military personnel about $5 billion in goods, which have a commercial retail value of over $7 billion (according to price surveys commissioned by DeCA). Thus, $1 billion in commissary appropriations yields $2 billion in benefits. The department's case for exchanges is even simpler: they offer savings to service members and at the same time generate revenue to support the military's MWR programs.

That assessment, however, overlooks costs that fall outside DoD's budget. In addition to appropriated-fund support, DoD's retail activities receive a subsidy from society in the form of exemption from state and local taxes, a monopoly over on-base retail sales, and interest-free use of federal capital (from society's perspective, it is just as costly to invest federal capital in a commercial activity as it is to invest private capital). Conceptually, the total subsidy is the difference between what patrons pay for goods and services in DoD stores and what it costs society to provide those goods and services.

The Congressional Budget Office estimates that in 1995, the total subsidy cost of DoD's retail operations in the United States was approximately $2 billion (see Summary Table 1). Forgone state and local taxes and the forgone return on capital accounted for most of that subsidy. Those costs are not evident to DoD, however. From the department's perspective, the subsidy cost of its U.S. retail activities was only about $600 million in 1995. U.S. exchanges generated resources for DoD to spend, although from a societal perspective they required a subsidy of more than $800 million.
 

Subsidies that are not paid by DoD help explain how the exchanges can sell goods at below-market prices and still generate earnings that, as a percentage of sales, are similar to those of private retailers. CBO found that most exchange earnings come from a few activities that benefit heavily from the exchanges' monopoly over retail activities at military bases, access to interest-free capital, or immunity from state and local taxation. Such activities include pay-telephone concessions, fast food, alcohol and tobacco sales, and interest on credit card balances. Sales of general merchandise--a retail activity in which the exchanges face competition from off-base stores--did not generate any earnings in 1995, although they accounted for 73 percent of sales. One problem with DoD's retail role is that some of the activities it finds most profitable (such as providing low-cost tobacco, alcohol, and credit) are those that military leaders might otherwise not want to promote.
 

The Effectiveness of U.S. Retail Activities as a Form of Compensation

DoD's retail activities in the United States pass much of their $2 billion subsidy on to patrons in the form of below-market prices. That makes DoD stores one of the most important noncash benefits for service members and retirees. However, the actual value of those benefits to U.S. patrons will be less than the amount of the subsidy to the extent that the government is unable to manage resources as efficiently as private retailers, who are driven by competition. The benefits will also be less than the subsidy because subsidized prices distort service members' decisions about consumption. If it could be accurately determined, the difference between the subsidy and the value of benefits to patrons would measure the economic inefficiency (or deadweight loss) that subsidized DoD stores cause.

From a societal perspective, those U.S. stores would be a cost-effective alternative to cash compensation if the deadweight loss from using them to attract and retain a high-quality military force was less than the deadweight loss from relying on the tax system to raise revenue for paying additional cash compensation. Thus, the cost-effectiveness of DoD stores depends not only on the size of the subsidy and the amount of benefits that patrons receive (the two factors determining the deadweight loss), but also on the impact that those benefits have on DoD's ability to attract and retain a high-quality force.

Who Benefits?

The number of military retirees increased gradually throughout the Cold War era and now exceeds the number of active-duty personnel (see Summary Figure 1). As a result, DoD's commissary and exchange systems--originally justified as convenient and affordable sources of goods for service members living on military bases--now focus heavily on serving retirees, who must drive to bases to shop. In 1993, 54 percent of commissary sales in the United States went to retirees, compared with 39 percent to active-duty personnel and 7 percent to reservists. Retirees also appear to account for about half of exchange sales of retail merchandise, although some exchange services (fast food, barber-shops, pay telephones) are used primarily by people living and working on-base.
 

Summary Figure 1. Number of Active-Duty and Retired Military Personnel, 1960-1995

SOURCE: Congressional Budget Office based on Department of Defense, Washington Headquarters Services, Directorate for Information Operations and Reports, Selected Manpower Statistics, Fiscal Year 1995, DIOR/MO1-95 (1995).

a. Also includes families receiving survivor benefits.

That shift in the mix of patrons has implications for the cost-effectiveness of DoD's retail activities. A retail system that serves active-duty personnel who live overseas or in isolated U.S. locations, where the value of the benefit is greatest, or who are about to make career decisions is likely to have a greater impact on retention than a system that primarily serves military retirees. (Young, active-duty service members who are making decisions about reenlistment may consider the benefits they will receive as retirees, but such members tend to heavily discount the value of deferred benefits. Moreover, the value of future commissary benefits is uncertain because it depends on people's eventual income, family status, and geographic location.)

The three exchange systems influence the mix of patrons in their stores through decisions about what types and quality of merchandise to stock. Those decisions are complicated by the fact that selling discount goods to enlisted personnel in competition with Wal-Mart and other discount retailers is not very profitable. The types of merchandise that generate the greatest earnings for exchanges (including upscale gift items such as Lladro figurines, Coach handbags, and Villeroy and Boch china) are often those that are most attractive to retirees with discretionary income. Finding the appropriate balance between discount store and upscale department store has long been a source of controversy for the exchanges. But that controversy has intensified in recent years as the size of the active-duty force has declined.

How Do DoD's Prices and Commercial Prices Compare?

DoD's assessment of its commissaries and exchanges overstates the savings they provide to patrons in the United States. Price surveys commissioned by DeCA suggest that brand-name goods cost an average of 29 percent less in commissaries than in nearby supermarkets (including sales tax). Yet the average gross margin (sales receipts minus the wholesale cost of goods as a percentage of sales receipts) in U.S. supermarkets suggests that commissaries, which sell at 5 percent over wholesale cost, can provide average savings of only about 20 percent. The discrepancy between those two estimates of savings results in part from the tendency of shoppers to buy items when they are on sale. Industry margins reflect that shopping pattern, but price surveys like DeCA's, which identify the cost of a specific basket of goods on a particular day, do not.

Surveys commissioned by the three exchange systems appear to overstate patrons' savings in exchanges by an even greater amount. Those surveys indicate that exchange prices are about 20 percent below commercial prices (before sales tax). But customers' perceptions of how much they save, as well as comparisons between markups by exchanges and commercial discount retailers, suggest that exchange prices are only 5 percent to 10 percent below commercial prices (including sales tax). Customers' savings vary, however, depending on what kinds of goods they buy. Exchanges offer large savings on some types of merchandise, including tobacco, alcohol, and upscale items that discount retailers in the private sector do not carry. But enlisted personnel frequently say that commercial discount stores offer lower prices and a better selection of the kinds of merchandise they want.

What Is the Value of Savings to Patrons?

DoD's assessment of the value of its stores is also inconsistent with the economic principle that the actual value to consumers of a price discount is less than their apparent financial savings (that is, the difference between what their purchases cost with the price discount and what those same goods would have cost without the discount). The fact that service members typically shop in both DoD and commercial stores supports that principle. It is evidence that, despite the financial savings, not every dollar spent in commissaries and exchanges yields the same benefit. The last dollar that patrons spend in DoD stores gives them no more benefit than the last dollar they spend in private, unsubsidized stores (after taking into account nonprice factors such as the distance they have to travel to shop, the hours that the stores are open, and the selection of merchandise). If the benefit was greater, patrons would choose to spend more in DoD stores and less in private stores.

One drawback to using DoD's retail activities as a form of compensation is that it is difficult to assess accurately either the cost of the subsidy or the value of the benefits. Nonetheless, under the illustrative (but not unreasonable) assumption that the total value of benefits to patrons equals 80 percent of their apparent financial savings, the deadweight loss associated with DoD's retail activities in the United States is on the order of $700 million a year (see Summary Table 2). In that illustration, giving active-duty personnel benefits equivalent to $500 million in compensation through DoD's U.S. stores costs society $1.2 billion (the $500 million in benefits plus the $700 million in deadweight loss).
 

Alternative Strategies for DoD's Retail Activities

The Department of Defense has many important reasons, which are not readily captured in a cost-effectiveness analysis, to continue operating large retail businesses that offer below-market prices. DoD officials wish to preserve military tradition and protect a unique, cohesive military lifestyle. They may also want to avoid the windfall gains and losses involved in switching from a compensation system that relies on below-market prices to one that relies on higher pay or allowances. People who would lose from such a change include the many military retirees who rely on DoD stores (and who feel that the benefit is a right they have earned), commissary and exchange employees, and the network of manufacturers, brokers, and distributors who support the current system.

Yet one of the key reasons that DoD's retail role has grown and persisted is that most of the costs fall outside the federal budget. Alternative strategies for the future of that role can take either a budgetary or a social perspective. Strategies that take a budgetary perspective on costs would encourage DoD to maintain a large role in retail activities because those activities allow the department to benefit from subsidies that are not included in either its own or the federal budget. Strategies that take a social perspective would encourage DoD to face the full cost of its retail activities and thus limit its role. This study examines four alternative strategies for DoD's retail activities (see Summary Table 3). The first two focus on reducing budgetary costs; the third and fourth focus on social costs.
 

Alternative 1: Follow DoD's Current Plan

The Defense Department plans to maintain the size, scope, and pricing policies of its commissaries and exchanges while reducing the cost of operating them. Its approach is two pronged. First, it intends to pursue federal waivers and legislation that would free commissaries from some of the legal and policy constraints that limit their ability to control costs. Commissaries would then operate more like nonappropriated-fund activities--able to hire workers outside the civil service and to pay some of their operating costs from the revenue they would generate from suppliers or patrons. Second, DoD is examining ways to consolidate the three exchange systems. Doing so would reduce operating costs and increase the exchanges' ability to generate earnings for morale, welfare, and recreation programs.

CBO estimates that fully implementing that approach could save DoD up to $200 million to $300 million a year. One of the weaknesses of the approach, however, is that providing DeCA with the same freedom enjoyed by private enterprises will not necessarily lower costs as long as commissaries depend on the political budget process rather than on competitive markets for most of their operating income.

Alternative 2: Create a DoD Resale Authority

A second alternative would reduce the budgetary costs of DoD's retail activities by combining DeCA and the exchange systems into what DoD refers to as a resale authority. The resale authority could be organized as either a government corporation or a revolving fund with NAF-like personnel and acquisition rules. It would reimburse DoD for any support the department provided, and the difference between its receipts and expenditures in any year would be included in the federal budget.

This option would increase Congressional control over federal resources (nonappropriated funds) that are now outside the federal budget. In addition, it would provide large budgetary savings: perhaps $800 million to $1 billion a year. Such savings would allow the resale authority--viewed from DoD's perspective--to almost break even. Much of the savings would come from raising prices on all commissary items to exchange levels (a logical move under a consolidated system). Additional savings would come from freeing commissaries from the constraints under which they operate as part of a federal agency and from combining commissary and exchange stores at bases where separate facilities are too small to be economical.

One disadvantage of this option would be the impact that higher prices for commissary items would have on patrons. From a broad social perspective, another disadvantage might be that a DoD resale authority that did not require a large annual appropriation might receive little public scrutiny, despite the social costs it would impose. In order to operate with little appropriated-fund support, the resale authority would have to keep its exemption from state and local taxes and would have to emphasize those activities that generate the most earnings--including sales of upscale items and of low-cost tobacco and alcohol.

Alternative 3: Rely on Private Contractors

A third alternative would require DoD to use contractors for all on-base retail services. That would eliminate the need for the Congress to create and oversee unique, quasi-governmental retail organizations. Using contractors rather than in-house providers might also allow DoD to distinguish more clearly between decisions that benefit the retail enterprises and decisions that benefit service members and the department as a whole. Even more important, competition among prospective contractors would reduce the costs of operating on-base facilities. Because the exchange systems already rely on concessionaires to provide many consumer services (such as pay telephones, fast food, and barbershops), DoD has experience in writing and monitoring the kinds of contracts that would be necessary.

One problem with Alternative 3 is that private contractors at bases in the United States might face higher operating costs than DoD because they would have to pay state and local taxes and earn a return on their capital. In theory, that need not change the size, scope, or pricing policies of on-base retail activities. DoD could subsidize contractors so that they could pay taxes and earn a return on their capital and still provide the same goods at the same prices as DoD's in-house stores. (Summary Table 3 reflects that assumption.) In practice, however, that approach would pose serious budgetary problems for DoD. U.S. commissaries and exchanges, which have annual operating costs of $2.6 billion, benefit from $1.4 billion a year in forgone taxes and forgone return on capital. For many of those enterprises, the cost of taxes and of the required return on capital would outweigh any possible savings from more efficient operation by contractors.

Faced with the cost of subsidizing contractors, DoD would probably reassess the cost-effectiveness of below-market prices as a form of compensation. Although Summary Table 3 does not reflect this, DoD might allow contractors to charge higher prices, decreasing the size and scope of the department's retail activities in the United States. That would reduce the welfare of retirees who shop on-base. Moreover, unless the price increases were offset by higher compensation (as in Alternative 4), such a change would reduce the welfare of active-duty personnel and make it more difficult for DoD to attract and retain a high-quality force.

Alternative 4: Revise Incentives for DoD's Retail Activities

Under this alternative, DoD would pay the full cost of its in-house retail activities, including forgone taxes and the forgone return on capital. One way to achieve that would be to require DoD to make payments to the Treasury in lieu of forgone taxes and to borrow capital from a Treasury credit account at the pretax, private rate of return. The department would be free to choose between in-house and contractor-operated stores. It would also determine which activities to subsidize and to what extent. Active-duty personnel would receive bigger cash allowances to compensate for the higher prices they would face. (CBO's estimates of budgetary savings for Alternative 4 assume that DoD would offset the higher prices for active-duty personnel in the United States with additional cash allowances of $500 million a year and that savings from eliminating subsidies for overseas stores would be just offset by higher overseas cost-of-living allowances.)

If DoD faced the full costs of its retail program, it would have an incentive to objectively evaluate the benefits of that program (including intangible factors such as the impact on military cohesion). As a result, DoD might well limit the size and scope of its retail system to the point where the costs of additional activities were balanced by the benefits. Likewise, this alternative would give the department an incentive to assess the nonfinancial drawbacks of its current role. Those drawbacks include the extent to which running large retail businesses distracts DoD officials from their core missions, the impact that sales of low-cost tobacco and alcohol have on the health of service members, and the risk that access to goods at below-market prices will lead to fraud and scandal (as has sometimes happened in the past) or that black-market activities will under-mine the character of military communities.

Under this alternative, the Congress could in theory increase DoD's budget to cover the expected payments to the Treasury, thus giving the department enough resources to provide the same retail system at the same prices that it does today. Even if the Congress did so, however, DoD would probably choose to use those funds for other purposes and pass much the cost of taxes and capital on to patrons in the form of higher prices. As in Alternative 3, those price increases would change the size and focus of DoD's role in retail activities. The department might place greater emphasis on convenience stores and services (such as fast food, dry cleaning, and barbershops) that serve the needs of members living and working on-base and do not require subsidies to attract customers. Prices of alcohol and tobacco might rise to commercial levels, causing sales of those items to off-base patrons to fall. Except in a few isolated areas, DoD might prove unwilling to subsidize large retail stores designed to attract off-base customers with below-market prices. In addition, with the playing field between contractors and in-house activities leveled, DoD might choose to rely on contractors to operate the retail stores that remained on-base.

This approach would eliminate the incentives that drive DoD to operate retail activities that are not central to its military mission. Without requiring the department to give up subsidized prices or in-house stores as a form of compensation, it would encourage DoD to be objective about their full costs and benefits. As a result, Alternative 4 offers the largest savings from a social perspective, while protecting DoD's ability to maintain a high-quality force. However, it does not offer the greatest budgetary savings to either the department or the federal government. The reason is that as DoD's role in retail activities declined, off-base stores and the state and local governments to which they pay taxes would reap much of the savings. From the perspective of the federal budget, this option would save much less than Alternative 2 (a DoD resale authority) and slightly less than Alternative 1 (the department's current plan).
 

Selecting an Appropriate Strategy

Reducing DoD's retail role and increasing its dependence on cash compensation might be undesirable for many reasons. First, although the gains to society as a whole would be more than large enough to compensate all of the people who would lose, there would be no practical way to make offsetting payments to many of the losers--including military retirees, workers at DoD stores, and the private industry that supports the stores. Second, DoD is trying to cut the costs of its entire infrastructure in order to free up funds to buy new weapons. CBO's estimates indicate that from a budgetary perspective, DoD could save the most by creating a centralized resale authority that would capitalize on the department's retail role rather than reduce it.

Nonetheless, this study finds that the military's justification for its U.S. retail system--that it is a cost-effective alternative to cash compensation--is not credible when the costs that the system imposes outside the defense budget are taken into account. From a broad social perspective, DoD's tax-free status and its use of retail activities to generate revenue for MWR programs appear to have distorted the focus of a system that was originally designed to provide necessary articles of convenience to service members with limited shopping options. In addition, DoD's role raises issues that go beyond economic efficiency. The most effective military may be one that is free to focus on its central mission, rather than one with control of a $14 billion a year retail empire that employs 96,000 civilian workers and competes with private companies. Those concerns suggest that fundamental changes in the current system--including possibly altering the tax treatment of DoD's retail activities and eliminating price subsidies--deserve serious consideration despite their limitations from a budgetary standpoint.

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