Federal Investment

Report
December 18, 2013

The federal government pays for a wide range of goods and services that are expected to be useful some years in the future. Those purchases, called investment, fall into three categories: physical capital, research and development (R&D), and education and training. There are several economic rationales for federal investment. It can provide public goods that the private sector and state and local governments would not provide efficiently, such as national defense and basic scientific research. It can promote long-term economic growth—as education spending does by developing a skilled workforce, as R&D spending does by prompting innovation, or as infrastructure spending does by facilitating commerce. And it can support the work of the federal government by, for instance, providing the structures and equipment necessary to perform federal activities.

In 2012, the federal government spent $531 billion on investment, representing 15 percent of federal spending and 3 percent of gross domestic product (GDP). As discussed in this publication (shown below), those shares have remained roughly stable over the past 20 years, though investment by the federal government approached 4 percent of GDP in 2010 and 2011 after the American Recovery and Reinvestment Act of 2009 (ARRA, Public Law 111-5) temporarily expanded funding for a number of investment programs. Earlier, in the 1960s, federal investment represented more than 30 percent of federal spending and averaged nearly 6 percent of GDP. Nearly all federal investment takes place through discretionary spending, which is controlled by annual appropriation acts. Federal investment has gradually declined as a proportion of discretionary spending, from roughly 50 percent in the 1960s to about 40 percent today, and discretionary spending as a whole has fallen as a share of total federal spending since the 1960s. Caps on appropriations put in place by the Budget Control Act of 2011 will decrease future discretionary spending through 2021 relative to what it would have been if annual appropriations had grown at the rate of inflation after 2011.

 

Sixty percent of total federal investment in 2012—or $318 billion, which represented 2 percent of GDP—was for purposes other than national defense. Of that nondefense investment, 40 percent provided funding for physical capital, another 40 percent for education and training, and 20 percent for R&D. (Some of the nondefense investment was the result of ARRA’s funding increases for such activities as highway construction and elementary and secondary education, though the resulting spending had started to abate by 2012.) Defense activities accounted for the remaining 40 percent of federal investment and totaled $213 billion, which represented a little over 1 percent of GDP. About two-thirds of federal investment for defense purposes was devoted to physical capital and the rest to R&D.

 

How Does the Federal Government Support Investment?

The federal government supports public and private investment through several different mechanisms. In many cases, it makes the investment directly, such as when the Army Corps of Engineers constructs a dam or when a federal agency purchases computer equipment from the private sector. In other cases, the federal government makes grants to individuals or private-sector organizations, which then use the funds to make investments. Examples include the Federal Pell Grant Program for postsecondary education and the National Science Foundation’s research grants.

The federal government also invests through grants to state and local governments, which in 2012 represented 46 percent of its nondefense investment, or $146 billion. Those grants accounted for nearly two-thirds of federal investment in nondefense physical capital and for half of federal investment in education and training. State and local governments often have some latitude in determining how to spend the grant funds. Many federal grants require state and local governments to spend their own funds as well.

This report focuses on investment that the federal government makes either directly or through grants. However, the federal government also supports investment in other ways. One of them is through tax expenditures—credits or deductions that reduce the federal income tax liabilities of individuals and firms as a result of certain investments that they make or finance. Those credits or deductions can reduce the cost of investment for state and local governments as well. Defined narrowly, tax expenditures that support investment amounted to $141 billion in 2012. Of that sum, $87 billion supported investment in physical capital, mostly by excluding from taxable income the interest on public-purpose state and local government bonds and by allowing tax filers to accelerate the depreciation of equipment and therefore to take larger tax deductions earlier in the equipment’s life. An additional $42 billion supported investment in education and training, mostly through tax credits and deductions focused on higher education. The remaining $12 billion, which supported investment in R&D, was split roughly evenly between the cost of a tax credit for increasing research and the cost of allowing firms to deduct the cost of research and experimentation immediately. A more expansive definition of tax expenditures that support investment would also include those that reduced the cost of private investment defined more broadly, including investment in intangible or financial assets. For instance, the tax credits and deductions offered for retirement savings accounts amounted to $112 billion in 2012.

Other federal policies can also affect private investment. Tax policies, including individual and corporate income tax rates, can restrain or encourage economic activities by changing their relative prices. Regulatory policies influence investment by prohibiting or constraining certain activities, such as air pollution, or by necessitating others, as in the case of federal safety standards. And federal deficits (and surpluses) influence the amount of funds available for private investment and the cost of those funds. For example, when the federal government issues bonds to finance its deficits, the funds that investors use to buy those bonds are no longer available to finance private investment. In response to the increased federal borrowing, bond buyers may also demand higher interest rates from the government, which would generally raise interest rates throughout the economy and make it more expensive for people and firms to borrow for investment purposes.

What Does the Federal Government Invest In?

Observers define investment in different ways. In the view of CBO, there are three broad areas in which the federal government invests:

  • Physical capital includes structures, such as government buildings, transportation infrastructure, and water and power projects; major equipment, such as computers, machinery, and vehicles; and software. For spending on physical capital to qualify as investment, the physical capital must have an estimated useful life of at least two years. Most federal investment in physical capital for defense purposes is for purchases of major equipment, such as ships and aircraft. Investment in physical capital for nondefense purposes, by contrast, is dominated by transportation spending, which provides infrastructure that contributes to the functioning of the economy.
  • Research and development has three components: basic research, which seeks to discover scientific principles; applied research, which attempts to translate those discoveries into more practical matters; and the development of new products and technology. Federal R&D spending supports a wide variety of work in government laboratories, universities, and the private sector, including health research studies, basic research in physics and chemistry, and the development of weapon systems. R&D investment builds the stock of knowledge that helps expand the economy over time, and the academic research that it funds is essential to the training of future generations of scientists. Most of the R&D spending by the federal government that supports defense is focused on development, rather than on basic or applied research.
  • Education and training includes early childhood, elementary, secondary, and postsecondary education, which help produce a skilled, capable workforce that contributes to the country’s productivity. It also includes job training and vocational training for veterans and others, which likewise promote a productive workforce. Federal spending on education and training is thus an investment in the nation’s human capital.

The Office of Management and Budget includes the same three categories in its own analysis of federal investment. The Bureau of Economic Analysis (BEA) includes in its calculation of federal investment most of what CBO identifies here, except for education spending. In particular, the investments in physical assets and R&D presented in this report are roughly comparable to two line items in BEA’s tables of the national income and product accounts (NIPAs): gross federal government investment, which includes investments made directly by the federal government in structures, equipment, software, and R&D; and capital transfer payments, which are mostly grants to state and local governments for the purpose of investing in physical capital or R&D. R&D spending was first included in BEA’s definition of investment in July 2013, when the NIPAs were revised to count expenditures on intellectual property, including R&D, as investment.

In some cases, it is difficult to determine what qualifies as federal investment and what does not. For example, although this report regards spending on instruction and on the construction of school buildings as investment, it does not regard spending on health care and school lunch programs for children as investment, because those goods and services are promptly consumed. Yet keeping children healthy and nourished improves their ability to learn and produces a healthier and more capable workforce in the future.

How Does the Federal Government Account for Investment?

For accounting purposes, the federal budget treats most investment the same way it treats other spending: on a cash basis. That is, expenditures on investment are recorded as they are made, just as other expenditures are recorded as they are made and revenues are recorded as they are received. Two important advantages of that approach are that transactions are readily verifiable and that the sum of all transactions provides a close approximation of the government’s annual cash deficit or surplus. However, accounting on a cash basis makes investment appear expensive relative to other government purchases, because many of the benefits associated with it do not arrive until well after the initial investment has been made. For example, building a highway takes a large initial investment, but its benefits last for decades. By contrast, the benefits of other federal spending occur closer to the actual expenditure—for example, when air traffic controllers safely direct flights. Therefore, the current budget system may provide incomplete information to policymakers as they decide how to divide federal resources between investment and competing priorities.

Some policymakers have proposed creating a capital budget for investments that would allocate current capital costs to the future, spreading them over the period when an investment’s benefits occur. That approach, which relies more on accrual-based accounting than on cash-based accounting, would be similar to the one used in the private sector. Adopting a capital budget for investments would not be likely to have a noticeable impact on the federal budget balance, because even though the cost of current investments would be spread out over future years, the federal budget would also have to show the depreciation of investments made in previous years. Nevertheless, the proponents of a capital budget argue that it would clarify the potential benefits of investment over time.

It is not certain, however, that a capital budget would provide better information to policymakers than they currently have. Several factors could make such a budget more complex and less transparent:

  • The budget process would become sensitive to small changes in assumptions about the depreciation rates of assets within the capital budget and about how those rates should be adjusted over time to account for inflation and for changes in the assets’ replacement cost. A system in which those valuations were not made transparently could encourage manipulation. And no depreciation schedule chosen would be likely to track changes in the economic value of an asset perfectly.
  • Because so much government spending could be viewed as providing benefits over an extended period, it would be difficult to determine what to include in the capital budget. An overly narrow focus would, by leaving some investments out of the capital budget, make them appear relatively expensive and therefore less desirable. An overly broad focus could turn the capital budget into a device for understating the cost of federal spending. The capital budgeting process could lead proponents of particular programs to try to have them classified as capital spending to lower their current costs and to advocate, too, for longer depreciation periods.
  • Policymakers would have to decide whether to include within the capital budget assets that the federal government does not own but does help fund. Roads, airports, and mass transit systems, for example, are often paid for in part by the federal government and in part by the state and local governments or independent authorities that own them. Federal investments in those assets could be excluded from the capital budget because the federal government does not own them. However, excluding those investments would make them appear expensive relative to other federal investments that were included in the capital budget.

What Are the Benefits of Federal Investment?

Most federal investment for nondefense purposes contributes to the economy on an ongoing basis by improving the private sector’s ability to invent, produce, and distribute goods and services. Defense investment contributes to the production of weapon systems and other defense goods, but much of it is sufficiently separate from domestic economic activity that it does not typically contribute to future private-sector output; the exception is the small portion of defense investment that goes to basic and applied research.

Federal nondefense investment can contribute to private-sector productivity in various ways. Without public highways, the cost to the trucking industry of delivering goods would be much higher; if the Internet had not initially been developed through government R&D, whole segments of the economy would not exist; if not for receiving a public education (funded in part by federal spending), many workers would have lower wages than they do. In CBO’s view, the government has made higher productivity possible in those cases by making investments that the private sector would not have made on its own or would have made in smaller amounts than their broad public benefits would justify.

The result of that higher productivity is higher private-sector returns. However, the size and nature of those returns are subject to considerable uncertainty, and some of the factors that contribute to that uncertainty are important considerations for policymakers facing decisions about how—and how much—the federal government should invest:

  • It can be difficult to know which outcomes to attribute to which investments. Scientific and technological discoveries often build on prior work, making it hard to determine how great a share of a new product to attribute to a particular earlier investment. Similarly, workers’ skills are the product of education funded not only by the federal government but also by state and local governments, the private sector, and the workers and their families.
  • Realizing the benefits of federal investment may take many years, and the timing varies for different types of investment. A new highway can improve transportation as soon as it is built, but it may take longer to realize the benefits of basic research or elementary education—which may also complicate the already difficult task of identifying those benefits.
  • The benefits of federal investment are unlikely to be distributed evenly. Firms located near highways will probably enjoy greater returns from those highways than will firms located farther away. Recipients of federal grants for R&D may acquire patents based on their work; though products and innovations based on those patents may benefit consumers, they may also earn returns for the patent owners that are not shared with the country as a whole.
  • Federal investment may discourage investment by private entities or by state and local governments by raising the price of investment goods. If that happens, and if the discouraged investment would have had positive economic returns, then the overall returns to the federal investment will be lower. Further, state and local governments may use federal spending to fund investments that they would otherwise have made with their own funds. (In some cases, however, federal spending on investment could increase state and local investment, because some grant programs require state and local governments to invest as well.)

Acknowledging those sources of uncertainty, CBO uses a range of returns when estimating the effect of federal nondefense investment on the private sector. At the high end, CBO estimates that federal investment yields the same return as average investment completed by the private sector. At the low end, CBO estimates that federal investment has a rate of return of zero—that is, that it has no effect on future private-sector output. The actual rate of return for a particular investment could lie outside that range; the project might have a negative return or, alternatively, yield a greater return than investment completed by the private sector.

Sometimes, policymakers may support investments not to achieve the largest expected economic returns but to accomplish other federal goals, such as defending the country or reducing inequities. At other times, the federal government may rely on policies other than investment to reach particular ends. For example, instead of investing to expand capacity on busy highways, the federal government might encourage state and local authorities to manage the high demand with congestion pricing—that is, charging drivers higher tolls at busy times and places. Even if an investment’s benefits would have exceeded its cost, the alternative policy may produce comparable benefits at a lower cost, thus allowing policymakers to find other uses for the funds that would have paid for the investment.