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Public interest has become widespread in having the federal government invest in private securities (such as stocks and bonds) as a way to increase the flow of budgetary resources to the government. This Congressional Budget Office (CBO) paper--prepared at the request of Senator Pete V. Domenici, in his capacity as Chairman of the Senate Budget Committee--discusses the key effects of such investment on the U.S. economy and on the government's ability to meet its future obligations. The paper also describes alternative ways in which federal investment activity could be treated in the budget. Although some proposals call for investment to occur through individual retirement accounts, this report focuses on direct federal investment in private securities through the general fund of the Treasury, program accounts, or federal trust funds. Douglas Hamilton, Deborah Lucas, and Marvin Phaup of CBO prepared the paper under the direction of Robert Dennis and Roger Hitchner. Barry Anderson, Tumi Coker, Paul Cullinan, Peter Fontaine, Geoffrey Gerhardt, Arlene Holen, Ben Page, Robert Sunshine, and Thomas Woodward of CBO contributed to the report. Christian Spoor edited the paper, and John Skeen proofread it. Annette Kalicki prepared the electronic versions for CBO's Web site. Dan L. Crippen
Summary and IntroductionOver long periods, private securities (particularly corporate stocks) have shown significantly higher rates of return than securities issued by the U.S. Treasury. Between 1926 and 2000, for example, the average annual return on large-company stocks (adjusted for inflation) was 7.7 percent, whereas comparable returns on Treasury securities were 2.2 percent for long-term bonds and 0.7 percent for short-term bills.(1) Those higher rates of return have led some observers to suggest that federal social-insurance programs, including Social Security, could benefit from investing in private securities. In 2001, the Congress took an unprecedented step in that direction by authorizing the Railroad Retirement system to invest its account balances in stocks, corporate bonds, and real estate.(2) Federal investment in private securities has both advocates and critics. Some proponents argue that such investments will produce higher returns than the traditional portfolio of government bonds and thus will ease the government's burden of paying for its future obligations. Other supporters believe that investment policies can be designed so as to provide benefits to households who do not participate in the stock market now and implicitly improve their access to the returns on private securities. Opponents counter that the higher returns are illusory in important respects because the government will be assuming risks that are costly and difficult to evaluate. Some critics also worry that the government might become overly involved in corporate governance and that its investments could become politically motivated. This Congressional Budget Office (CBO) paper addresses those issues, focusing on the broader effects that government investment in private securities would have on the federal budget and the economy. In particular, the paper examines several questions: what are the likely effects of such investment on the nation's economy; will such investment make it easier for the federal government to meet its long-term obligations; is the government's involvement in securities markets likely to distort market signals or corporate decisions; how might such investment affect the Congress's and the President's control over the budget; and how should the investments themselves be treated in the budget? In many cases, the answers to those questions would depend on the precise form of a particular investment proposal. Nevertheless, CBO's analysis yields some general conclusions:
In some respects, an analysis of government investment in private securities
is similar to an analysis of proposals that would allow people to invest
some of their Social Security taxes in private securities. However, such
proposals, which would rely on private accounts, raise a number of additional
issues that are beyond the scope of this paper.(3)
The Economic and Budgetary Effects of Federal Investment in Private SecuritiesThe government could invest in stocks and other private securities in a variety of ways. For example, program administrators or their agents could make the investments--as is the case with the Railroad Retirement system--or the Treasury could buy a portfolio of securities on behalf of the government's general fund. Program benefits that were financed from holdings of private securities could be fixed at the current statutory level or could be adjusted up or down depending on the returns from those investments. Those variations raise many important issues, but in all cases their effects on the macroeconomy, on the outlook for the federal budget, and on overall social welfare would depend critically on how the government raised the funds to purchase private securities and how the gains and losses from those investments were distributed among taxpayers and program beneficiaries. How Would Government Investment Affect the
Economy?
Effects of Redistributing Risks and Returns. Any substantial redistribution potentially affects the economy, and the implicit redistribution arising from government investment in private securities is no exception. Such investment would change people's expectations about their future after-tax income, which in turn would influence their decisions about how much to save and work. And if the government's investments were large enough, they could have a noticeable effect on capital accumulation, labor supply, and total income in the economy. Predicting whether such investment would raise or lower the growth rate of the economy is impossible because the answer hinges on assumptions about future policies and about people's expectations and responses--all of which are uncertain. In particular, the way in which people responded would depend on what they thought policymakers would do with the gains or losses from the government's investment portfolio. A variety of plausible scenarios exist, and each would have a different influence on the economy. Under some assumptions, the nation's gross domestic product (GDP) could fall; but under other assumptions, it could rise.(4) One possibility is that current and future beneficiaries of federal programs that were financed through private securities might expect benefit payments to rise when the stock market did well but expect to be protected from benefit cuts when the market performed poorly. That view would lead them to expect a higher lifetime income than would otherwise be the case, which means that they would probably save less and consume more. Lower saving rates would reduce the accumulation of capital over time, slowing the growth of the economy. Alternatively, beneficiaries might believe that they would share both the gains and losses of the stock market through higher or lower benefit payments. With that view, some people might save more to protect themselves against the risk of reduced benefits, and that additional saving would increase GDP. Taxpayers could also have different expectations about future tax burdens, which could influence their decisions about saving. Although most taxpayers would probably not change their saving plans, some people might save more to hedge against the risk that the government would raise taxes in the future to cover stock losses. Others might save less if they thought that unexpected gains from the government's stock investments would accrue to them in the form of lower taxes. Government investment in the stock market could also affect the distribution of risks and returns--and hence investment incentives--through its effects on the prices of financial securities. Some models predict that a large government investment in the stock market would raise the price of stocks and reduce the price of debt. As a consequence, interest rates on government and other debt would rise, and returns on stocks would fall. Those results stem from the fact that for the government to induce private investors to buy additional government debt and sell stocks, interest rates on bonds would have to rise relative to the expected returns on stocks. Whether those relative price changes would alter overall private investment is uncertain, but there are reasons to expect that any effect would be small. For one thing, companies' investment decisions depend on changes in overall financing costs, and those costs in turn depend on the total supply of and demand for investment capital, not on the cost of either debt or stocks alone. The Means of Financing Purchases. The way in which the government financed the purchase of private securities could also have consequences for the economy. The government could raise funds for those purchases by issuing debt, cutting spending, or raising taxes. Even using the tax revenues allocated to federal trust funds (such as the Social Security trust funds) to buy stocks would not let the government avoid some form of new financing because those revenues would no longer be available to cover other expenditures. Issuing debt to buy private securities would be an equal-value swap between the private sector and the government, so it would primarily affect the economy through the redistribution of risks and returns. Other means of financing would have additional effects. Cutting spending could raise GDP by increasing savings. Raising marginal tax rates, by contrast, could reduce GDP if the higher rates significantly discouraged people from saving or working more. Those outcomes, however, would depend on how taxes and spending affected overall saving and the labor supply--not on the fraction of stocks that the government held in its portfolio. Thus, those effects would be logically distinct from the government's portfolio decisions. Regardless of how the investments were financed, there remains a fundamental difficulty in projecting how future policymakers would redistribute the risks and returns of the government's investments in private securities. Thus, the net effects on the economy of those investments are necessarily ambiguous, as they depend on many types of future as well as current policy choices. Potential Implications for Corporate Governance. Government investing could also influence investment and capital accumulation through its effects on corporate decisionmaking.(5) Federal ownership of private stocks would give the government partial ownership of the underlying companies. Ownership conveys voting authority in the selection of top management. If the government exercised that authority, it might influence the selection of managers and thus the criteria that managers used to identify investment projects. Many observers have expressed the fear that such influence would result in less productive investments. Yet, if the government tried to avoid those distortions by refusing to exercise its voting rights, and voting power shifted in favor of insiders, corporate managers might not receive sufficient oversight. A related concern is the potential for government favoritism toward companies in which it had a large stake. Even if the government's investments were spread broadly through the economy, large government holdings could result in some reallocation of capital. For example, it might be impractical for the government to buy every stock for its portfolio. Companies that were not included could experience a higher cost of capital than firms that were included. (A similar effect is evident in the tendency of a stock to rise in price when it is added to the Standard & Poor's 500 index.)(6) Evidence from the states, however, suggests that although government investments are sometimes influenced by political as well as economic considerations, the overall returns on government portfolios have not been markedly affected. State pension funds held almost $1.3 trillion in corporate stocks and bonds in the third quarter of 2002.(7) In some documented cases, investment policies reflected political concerns, and as a result, the funds' portfolios suffered losses.(8) Nevertheless, the overall returns on investments in state and local pension funds were similar to the returns on investments in private funds (adjusted for differences in the size and composition of the portfolios).(9) That result suggests that political considerations may not have greatly interfered with the pursuit of market returns for many state funds. But whether that result would apply to potentially much larger federal investments--with a much greater capacity to influence corporate behavior and the economy--is unclear. Some countries have also built up large holdings of government-owned private assets.(10) Norway, for example, has accumulated net assets (mainly foreign stocks and bonds) totaling about half of its GDP in 2002. The nation's independent central bank manages those investments, which may lessen some of the concern about portfolio choices being affected by political considerations. In addition, because the country is relatively small, its actions would not be expected to affect world financial markets to any appreciable extent. Moreover, Norway's decision to invest mainly in foreign securities limits its potential scope for distorting the activities of its private sector. The United States, by contrast, is unlikely to have the option or inclination to invest solely in foreign stocks. Would Government Investment Improve Social
Welfare?
Several reasons exist to be skeptical about those arguments. To achieve
the benefits of risk sharing, the losses as well as the gains from government
investments in private securities would have to be distributed to people,
and low-income households could be most vulnerable in the event of such
losses. Clearly, whether or not the government would actually distribute
losses to low-income beneficiaries of federal programs is an open question--but
one that is critical for assessing the welfare implications of an investment
policy. Moreover, the government already provides implicit access to the
risks and returns of the stock market because tax revenues are significantly
affected by the performance of the market.
Would Government Investment Reduce the Burden
of Meeting Future Long-Term Obligations?
That argument, however, confuses higher balances in trust fund accounts with greater national resources. Federal trust funds do not measure the real resources available for future payments; rather, they are accounting mechanisms designed to record program spending and collections of earmarked revenues. To pay program benefits, the federal government must acquire real resources from the private economy. Other things being equal, the larger the economy, the lower the burden of financing any given level of long-term obligations. Thus, the government's ability to meet its future commitments--whether Social Security benefits or some other obligation--depends on the total resources of the economy and the willingness of taxpayers to fund those programs, not on the account balances attributed to various trust funds. However, as discussed earlier, government investment in private securities would have an unpredictable effect on the economy. Thus, such investment is a fairly risky approach to meeting the nation's long-term obligations to an aging population. Even in the narrow context of trust fund accounting, investing in stocks is not a reliable way to increase trust fund balances. Although stocks can be expected to outperform bonds, on average (a difference often referred to as the "equity premium"), the performance of the stock market is never certain. Indeed, even over long periods of time, there is a chance that stocks could perform worse--perhaps much worse--than bonds. According to historical data, investors face about a 25 percent chance of realizing lower returns from holding a portfolio of S&P 500 stocks for 10 years than from holding 10-year government bonds over the same period.(11) Even during the great postwar boom of the past 50 years, stocks have returned no more than Treasury debt in some long periods. For example, between 1966 and 1981, the real rate of return on stocks was -0.4 percent, lower than the real rate of return on short-term Treasury securities (-0.2 percent).(12) More recently, in the 12 months that ended on September 30, 2002, the S&P 500 portfolio fell by 20.5 percent, while bonds (as measured by Barclay's U.S. Debt Index) provided returns of 8.6 percent. It is the risk of greater potential losses that causes investors to
demand a premium to hold stocks rather than bonds. Stocks must provide
higher returns than bonds, on average, because otherwise no one would be
willing to invest in them. (For the implications of that difference for
government investment in private securities, see Box 2.)
How Would Government Investment Affect Control
of the Federal Budget?
Rules could be adopted, however, to limit the discretion of program
administrators and to assign responsibility for investment losses. For
instance, in the case of the legislation requiring private investment by
the Railroad Retirement system, tax payments earmarked for the program
are partially tied to investment returns, which may help insulate general
taxpayers from investment losses. Under that law, most of the risk is borne
by current and future railroad employees.
Accounting for Government Purchases of Private SecuritiesInvestment in private securities is a significant departure from traditional federal transactions. As such, it poses major challenges to existing budget concepts and practices, which were developed largely to report and control tax revenues and spending. Several different means of accounting for such investment in the federal budget have been proposed, each of which has advantages and disadvantages. The most basic question about the budgetary treatment of federal investment in private securities is whether the investment activity is federal and hence belongs in the budget. For example, a voluntary pension plan that is administered by the government without federal financial support is effectively private and should be excluded from the budget. That is the status of the Thrift Savings Plan for federal employees, which is administered by the government solely on behalf of beneficiaries and holds investments in a fiduciary capacity for private owners. Certain Indian tribal trust funds are similarly held and administered by the federal government and are not included in the federal budget. That exclusion might also apply to individual retirement accounts financed with payroll tax dollars, if (as with the Thrift Savings Plan) participation was voluntary, beneficiaries were entitled to the balances in those accounts, and the accounts had no explicit or implicit federal guarantee of a minimum value.(13) Under most proposals for direct federal investment in private securities, the investment activity would be unequivocally federal because it would be undertaken at the initiative of the government, the funds invested would be federal, and the gains and losses would accrue to the government. In other cases, with different degrees of federal control and ownership, difficult judgments would be necessary to determine the appropriate budgetary status of the investment activity. Alternative Budgetary Treatments of Federal
Investment Activity
Cash-Basis Accounting. Under the cash-basis treatment, the budget would not distinguish between buying private securities and spending the same amount to buy office supplies, an airplane, or a building. Indeed, OMB's Circular A-11 directs that all federal purchases of assets receive the same treatment and be shown as outlays. Purchases of goods and services and transfer payments are all recorded as outlays when the funds are disbursed. That treatment implies that when the government buys private securities, the budget should record an increase in outlays--and an equal increase in the deficit or decrease in the surplus. Similarly, when the government sells securities or receives interest and dividends from its investment holdings, the budget should record negative outlays (offsetting receipts) for the amount of cash received. Accrual (Non-cash-basis) Accounting. An alternative to cash-basis accounting for financial investments is suggested by the current budgetary treatment of federal direct loans, such as student loans and home mortgages. Those loans are not counted as budget outlays.(14) Instead of raising the budget deficit or reducing the surplus, those transactions simply increase the government's borrowing from the public. Similarly, loan repayments and loan sales that do not involve gains or losses to the government leave budget outlays, receipts, and the deficit unchanged, but they are shown as reducing the government's borrowing from the public. However, unexpected gains and losses on loans are treated as reestimates and are reported as negative and positive outlays, respectively, in the year they occur. Whether making a direct loan or buying stocks and bonds, the government is acquiring a claim on uncertain future cash flows. That similarity between private loans, stocks, and bonds constitutes a precedent for the general noncash accrual approach used in accounting for federal lending (although not necessarily the specific account structure or procedures). That approach could provide an alternative budgetary treatment of federal investments in marketable stocks and bonds. Under that approach, purchases and sales of private securities would be treated as transactions affecting federal borrowing from the public but not outlays or the budget deficit. Interest income, dividends, and capital gains (or losses), however, would be recorded as collections, which reduce (or increase) outlays. If, for example, the government bought $1 million worth of stocks in the open market, net budget outlays would be unaffected. If, however, the market price of those shares later declined to $750,000, the budget would record an outlay of $250,000 corresponding to the government's loss. Conversely, an increase in value would trigger the recognition of a gain through an increase in offsetting collections and a decline in outlays. Thus, the focus of measurement under that approach is on actual gains and losses rather than on the initial outlay of cash for equal-value securities. Evaluating the Alternatives
The Case for Cash-Basis Accounting. The government differs fundamentally from private companies, most significantly in its ability to compel the payment of taxes. With that authority, the government is not constrained in its financial transactions by the need to persuade investors to commit their capital to a particular enterprise. Instead, investors who buy Treasury securities lend money to the government for general purposes, confident that the debt is backed by the government's ability to tax rather than by the financial success of any planned expenditure. The government, therefore, is exempt from a major financial check and balance that applies to private firms. Cash-basis accounting is a partial substitute for that missing market discipline. It requires policymakers and the public to recognize the entire amount of taxpayers' funds placed at risk by a transaction. Cash-basis accounting also contributes to fiscal discipline and transparency by treating all expenditures identically and thus avoiding the need to make arbitrary distinctions between assets. Those distinctions can be arbitrary because in some cases, it is difficult to draw a clear line between capital assets and goods or services for consumption. Some types of current expenditures, such as inventories of supplies, have attributes of capital, and capital assets do provide current (and future) consumption benefits. Even expenditures for labor are likely to produce services (environmental protection, defense, health) that will yield benefits in the future. Applying non-cash-basis accounting to the acquisition of some assets but not to others that provide similar services--as some observers have proposed--could distort choices between various assets.(15) Proponents also argue that maintaining a cash-basis treatment of federal investments in private securities is consistent with the allocative purpose of the budget. As the central element in federal financial planning, the budget requires a comprehensive measure of the use of resources for alternative purposes. The full measure of financial resources allocated to each use is the amount of cash disbursed or received in every transaction. Cash-basis accounting ensures full recognition of the funds allocated to each activity. Some advocates emphasize the principle that the budget should reflect all potential losses from an obligation at the time it is incurred. The federal government is at risk of losing its entire investment in private securities as soon as those securities are acquired, since there is some chance that they will never pay off. In that view, the budgetary cost of such an investment is the full purchase price--and should be recognized at purchase. Finally, some budget analysts have argued that cash-basis accounting helps preserve the link between the budget deficit or surplus and borrowing from or debt repayment to the public. The annual deficit or surplus is widely regarded as a measure of changes in total federal debt held by the public. Purchases of private securities increase federal borrowing from the public (or reduce debt repayment) just as any other purchase or transfer payment does, and that fact is reflected when such purchases are reported on a cash basis.(16) The Case for Accrual Accounting. The main advantage of accrual (noncash) accounting is that it more accurately reflects the change in the government's economic position as a result of a security purchase, both initially and over time. The initial purchase of a security generally implies no change in the financial status of the government. Government securities are sold for cash that is exchanged for an asset of equal value. Equivalently, the present value of the promised cash flow that the government will receive in the future equals the price paid. Over time, however, security prices change as new information about the performance of the underlying companies and the economy in general becomes available. Capital gains and losses, whether or not they are realized, are changes in the value of resources available to the government. When the government holds private securities, its ability to meet obligations using invested funds is reduced by the amount of any capital losses and increased by the amount of any capital gains. Accounting for the purchase of securities on a cash basis fails to reflect those economic effects. Cash flows expected to occur within the period covered by the budget are not discounted for the time value of money or for uncertainty, and cash flows expected to occur after that period are ignored and thus assigned a value of zero. As a result, a security purchase (or sale) can have a significantly positive (or negative) effect on the budget deficit even though the financial condition of the government does not change. Furthermore, no changes in the market value of the security are recognized, since those changes are not an actual cash flow. In fact, under cash-basis accounting, if the government sold the security after a large fall in its value, the budget entry in the year of the sale would show a positive inflow that reduced outlays and the deficit because some cash would be received. Another disadvantage of the cash-basis approach is that by treating investments in financial assets as equivalent to purchases of goods and services, it overstates the use of budgetary resources in the period of the purchase and understates the use in the period of sale. That is, if the purchase occurs in one budget period and the sale in another, then outlays (a proxy for the use of budgetary resources) will rise in the purchase period and fall in the sale period. Such a direct effect of purchases and sales of securities on the deficit could also tempt future policymakers to "manage" the budget's bottom line by buying and selling securities to shift outlays between fiscal years. Adopting some features of the noncash approach now used for direct loans would address those issues by insulating outlays and the deficit from the cash flow effects of purchases and sales of private securities. Only subsequent changes in market value (gains and losses on investment holdings) would be included in outlays and the deficit. Excluding stock purchases from outlays avoids the implication that investing in financial assets is costly in the same way as spending for goods and services. It would also foreclose the possibility of manipulating the deficit through strategic timing of security purchases and sales. At the same time, requiring that gains or losses on investments be reported as negative or positive outlays would reflect the effect of changes in asset values on the government's finances. Applying the current accounting method for government loan programs without modification, however, would only partly reflect the financial consequences of security transactions in the budget. In particular, two features of that method--the rule for discounting future cash flows and the exclusion of associated administrative costs--would result in budget entries that tended to understate the costs and overstate the benefits of investments in securities. The Credit Reform Act requires that future cash flows from loans be discounted at the government's borrowing rate rather than at a rate that reflects the risk of the loan. Because stock investments are riskier than government securities, discounting at the government rate could result in reported valuations that significantly exceeded the economic value of those investments. Cost estimates of proposals that include guaranteed floors on investment returns would be biased downward under the current policy of discounting at a risk-free rate. (For more about risk-adjustment in discounting, see Box 2.) Moreover, because most of the assets that the government would probably hold in its portfolio would be publicly traded, there would be less need to discount future cash flows to calculate the market values of the assets. The values of assets such as stocks are priced every day in the financial markets, and the government would be able to estimate the value of its portfolio without having to make assumptions about discount rates and future cash flows. The Credit Reform Act also requires that administrative costs for loan programs be treated on a cash basis. To the extent that program accounts should reflect all of the associated expenses for the life of the loans made in a budget year, that requirement tends to understate program costs. In the case of stock and real estate investments, where the associated administrative costs could sometimes be sizable, that treatment could misrepresent the cost of the investments. In evaluating the two accounting approaches, the advantage of more accurately reflecting changes in the government's financial position under noncash accounting must be weighed against the fiscal discipline and transparency that could be lost from not using cash-basis accounting for security investments. As in most budget accounting matters, political judgment is required.(17) Projecting Future Budgetary Resources
One approach is to assume that a private security will earn its expected return each year in the future. That expected return might be based on historical averages, or it could reflect the government's current assessment of the market's prospects. If government debt was used to finance the investment, the projected gain would depend on the difference between the expected return on the private securities and the government's cost of funds. For example, consider the purchase of $1 billion of a stock, with an expected return of 7 percent each year, financed by government debt with an expected return of 3 percent each year. That difference of 4 percentage points is the equity premium required by investors to accept the higher risk of the private security (see Box 2). At the end of five years, the stock would be projected to have a value of $1.4 billion, and the government debt, with accumulated interest, would total $1.16 billion. Thus, the transaction would net an expected gain of $240 million over five years, compared with the result from the current policy of investing only in government bonds. The most serious shortcoming of that approach is that it would allow lawmakers to create the appearance of new budgetary resources (sometimes incorrectly described as "arbitrage profits") simply by issuing more debt and buying risky private securities with the proceeds. The reason is that such an approach neglects the effect of risk on the value of securities--and hence on expected returns. Ignoring risk overstates the future resources available to the government because it fails to take into account the cost of that risk for future taxpayers (see Box 1). Budget analysts can avoid the appearance of arbitrage profits by using
a risk-adjusted interest rate to value expected gains from investments.
In other words, they can use a Treasury rate (the standard proxy for the
required return on a risk-free investment) to calculate the expected risk-adjusted
returns on any investment portfolio. That method ensures that investments
with equal current values are projected to have equal risk-adjusted values
in the future. Similar adjustments for risk are required in accounting
for private pension plans, to prevent those plans from setting aside too
little to cover their future liabilities to beneficiaries.
The Case of the Railroad Industry Pension FundA decline in railroad employment has weakened the financial condition of the Railroad Retirement system to the point that the Railroad Retirement Board's Bureau of the Actuary has characterized the system's long-term stability as "questionable."(18) Nevertheless, the Railroad Retirement and Survivors' Improvement Act of 2001 (P.L. 107-90) raised retirees' benefits and reduced taxes as it authorized the new National Railroad Retirement Investment Trust to invest in corporate stocks, bonds, and other assets. Anticipating higher returns from the new investment strategy, the legislation intends to lower financial burdens for railroad workers and employers and to provide larger pensions for retirees. The risk is that the retirement system's condition will worsen with investments in private securities and that taxes will need to be raised. Indeed, the Bureau of the Actuary's report for 2002 adds "investment return" to the sources of uncertainty that may require future "corrective action." In authorizing investment in private securities, the Congress stipulated that for budgetary purposes, "the purchase or sale of non-federal assets (other than gains or losses from such transactions) by the National Railroad Retirement Trust shall be treated as a means of financing"--that is, using the noncash approach. By directing the budgetary scoring and treatment of that activity, the Congress bypassed some of the analyses that OMB, the House and Senate budget committees, and CBO normally undertake to determine the appropriate budgetary treatment of a new activity. Nevertheless, important choices remained--including how to treat capital gains and losses and how to project the baseline. Those choices involved many of the considerations discussed earlier in this paper. Further, the Congress might not provide such direction in future legislation. Thus, the Railroad Retirement investment program offers a useful example to review the considerations that would guide budget analysts if they faced similar legislation and to illustrate the budgetary effects of using a cash versus an accrual approach. The Railroad Retirement system--one of the government's oldest social
insurance programs--is clearly a federal activity, so its investments should
be included in the budget. (For more information about that system, see
Box 3.) Moreover, it is clear that the system's new
investment activity will be more costly than past practices.
The system will engage in two new types of activity that will consume additional budgetary resources: buying and selling securities and holding risky assets. First, purchasing and selling private securities will entail various transaction costs, such as payments for investment advice and for the costs of acquiring and disposing of the securities. Although the RRB incurred and recognized some such costs in the past when it invested in Treasury securities, information and transaction costs will increase as investment alternatives expand to include the wide range of private debt, stocks, and real estate. Second, the RRB will now hold higher-risk assets that may experience larger declines in value. The Treasury "market special" issues in which the RRB invested in the past were subject to price fluctuations because of changes in interest rates and, thus, could create a cost for the program. However, losses to the Railroad Retirement Trust Fund were offset by gains to the Treasury--so that, for the government as a whole, those changes net to zero. By investing in those government securities, the Railroad Retirement program was simply placing a bet with the Treasury about interest rates. With investments in private securities, by contrast, gains and losses will not be offset elsewhere in the government. As directed in the 2001 law, purchases and sales of securities initially produce no direct budgetary cost. They are treated as a change in the composition of trust fund balances that affects federal borrowing and the means of financing the budget deficit or surplus. However, the law did not prescribe the treatment of unrealized capital gains and losses on those securities. CBO and OMB agreed that any capital loss or gain resulting from changes in market prices will be recognized in the year in which the price change occurs. Similarly, interest payments and dividends will be recorded as offsetting receipts. Under that treatment, income and capital gains will reduce outlays and the deficit, and losses will increase them. That treatment reflects the change in real economic resources available to the government from fluctuations in the value of investments in private securities and from the actual associated cash flows. The means-of-financing approach, combined with this method for recognizing capital gains and losses, is consistent with the observation that unless the value of the securities changes, there is no real change in the government's resources. Had the Congress not directed the accrual means-of-financing treatment for the Railroad Retirement system's investments, CBO and OMB might have used cash-basis accounting. In fact, CBO's cost estimate for the Railroad Retirement and Survivors' Improvement Act of 2001 (when it was H.R. 1140) used a cash-basis treatment for investments in private securities. Although that treatment was consistent with current law and practice as specified in OMB's Circular A-11, CBO noted that "because there is little precedent for the purchase of private securities by the federal government, alternative budget treatments are possible that could substantially alter the budgetary impact."(19) The two accounting approaches discussed in this paper would produce very different budgetary outcomes for the Railroad Retirement investments. In CBO's original cash-basis estimate, the projected initial purchases are the cash outlays to buy securities. Projected future returns in excess of Treasury rates, and proceeds from sales of securities, are shown as negative outlays in later years. The effect of those transactions is significant net outlays during the budget period (see Table 1). Under the means-of-financing approach, in contrast, substituting private for federal securities has no direct effect on the budget totals in the year of purchase. Since the 2001 legislation did not stipulate how to project future cash
flows from investments in private securities, CBO and OMB had to decide
how best to project the budgetary effects of those investments in later
years. To adjust the higher expected returns of private securities for
their increased risk, CBO and OMB opted to use the rates of return on Treasury
securities. Doing that is equivalent to equating the higher expected return
on stocks with the higher cost to the government of assuming the risk.
That treatment has the advantage of not requiring an explicit calculation
of the cost of risk. As a result, baseline projections of the deficit or
surplus are unaffected by the government's policy of acquiring private
securities for the Railroad Retirement Trust Fund.(20)
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