In 1995, we compared the 4 common years (1996-99) in DOD’s 1995 and 1996 FYDPs and reported that DOD projected substantial shifts in funding priorities. Specifically, about $27 billion in planned weapon system modernization programs had been eliminated, reduced, or deferred to 2000 or later. Also, the military personnel, operation and maintenance, and family housing accounts had increased by over $21 billion and were projected to continue to increase to 2001 to support DOD’s emphasis on readiness and quality-of-life programs. Moreover, the total DOD program was projected to increase by about $12.6 billion. The Secretary of Defense wants to reform the acquisition process and reduce and streamline infrastructure to help pay the billions of dollars that DOD projects it will need to modernize the force. In our September 1995 report, we said that although DOD anticipated reducing infrastructure to achieve substantial savings, our analysis of the 1996 FYDP showed that savings accrued or expected to accrue from base closures and a smaller force appeared to be offset by increased funding for other infrastructure priorities, such as base operations and management headquarters. In May 1996, we analyzed the infrastructure portion of DOD’s 1997 FYDP and reported that infrastructure costs are projected to increase by about $9 billion, from $146 billion in 1997 to $155 billion in 2001. The FYDP includes anticipated future inflation. Therefore, changes in anticipated inflation affect the projected cost of the FYDP. The Secretary of Defense testified in March 1996 that the 1997 FYDP, which covers fiscal years 1997-2001, includes the funds to buy all of the programs in the 1996 FYDP plus billions of dollars in additional programs at less cost overall. According to DOD, the increase in programs at lower projected costs results because inflation estimates were substantially reduced for future DOD purchases, from 3 percent to about 2.2 percent for fiscal years 1997-2001. The executive branch substantially reduced its forecast of the inflation rate for fiscal years 1997 through 2002, resulting in a decline in the estimated costs of DOD’s purchases of about $45.7 billion, including about $34.7 billion over the 1997-2001 FYDP period. However, the price measure used in the executive branch’s projections had inherent limitations and has since been improved. Using a different price measure, CBO projected a much smaller drop in inflation and estimated that the future cost of DOD’s purchases would be reduced by only about $10.3 billion over the 1997-2001 period. The executive branch reduced its inflation forecasts from 3 percent per year for the period 1997-2001 to 2.2 percent per year, or 8/10 of 1 percent.As a result, DOD projected that the cost of defense purchases would decline by $34.7 billion for the 1997-2001 period and an additional $11 billion for 2002. Based on these projected cost reductions, the executive branch reduced DOD’s projected budgets for fiscal years 1997-2001 by about $15.2 billion. The executive branch allowed DOD to retain about $19.5 billion of the projected increase in purchasing power. The distribution of this assumed additional purchasing power was $4.3 billion in 1997, $3.9 billion in 1998, $4.6 billion in 1999, $3.8 billion in 2000, and $2.9 billion in 2001. According to DOD, about $6 billion of the $19.5 billion was applied to the military personnel and operation and maintenance accounts for must-pay bills such as for the military retired pay accrual and ongoing contingency operations. The remaining $13 billion was applied primarily to DOD’s modernization priorities. Funding was allocated to purchase trucks and other support equipment, accelerate the acquisition of next generation systems, upgrade existing systems, and fund Army base closure costs. A detailed list of these planned purchases is provided in appendix I. For more than a decade, OMB has used projections of the Commerce Department’s Bureau of Economic Analysis’ (BEA) implicit price deflator for gross domestic product (GDP) based on a “fixed-weighted” methodology to adjust the future costs of defense nonpay purchases other than fuel. According to OMB officials, anecdotal information for recent years suggests that changes in this measure have been an accurate gauge of inflation in DOD purchases. The fixed-weighted methodology was used to prepare the President’s fiscal years 1996 and 1997 budgets. Economists within the government and in private organizations generally recognize that the implicit price deflator based on a fixed-weighted methodology has inherent limitations, in part because it is derived from the values of goods and services based on a fixed base year such as 1987. This fixed-weighted methodology has in recent years tended to overstate economic growth and understate inflation as time progressed beyond the base year. Because of the limitations in the fixed-weighted methodology, BEA switched to a new “chain-weighted” inflation methodology, just after the President’s fiscal year 1997 budget had been prepared in January 1996. The “chain-weighted” methodology, which is continuously updated by using weights for 2 adjacent years, ensures that differences in relative prices, such as the drop in computer prices, will not distort overall GDP statistics. Economists have maintained that this methodology is superior to the fixed-weighted methodology. According to BEA officials, the improved methodology gives a more accurate measure of inflation because it eliminates the potential for cumulative errors under the old (fixed-weighted) methodology. For the 1997-2001 period, the executive branch projected an annual inflation rate of 2.2 percent as measured by the fixed-weighted methodology and 2.7 percent as measured by the chain-weighted methodology. In discussing the transition from the GDP implicit price deflator based on fixed weights to the chain-weighted GDP price deflator, OMB officials stated that the two differing numerical measures represent the same inflation, in the same economy, at the same time. According to the officials, the difference is “precisely analogous” to measuring the same temperature on Celsius or Fahrenheit scales. The only difference between the two measures is the methodology used. However, as a practical matter, OMB provides DOD a specific numerical index of inflation, and DOD applies this index to estimate future funding requirements. Therefore, the index used has a direct impact on DOD’s estimated future funding requirements. For example, our analysis shows that had DOD applied the new chain-weighted inflation assumption of 2.7 percent to develop its 1997-2001 FYDP rather than the fixed-weighted assumption of 2.2 percent, DOD’s increased purchasing power would be only about $12.7 billion, not $34.7 billion. OMB officials told us they have not decided what methodology they will use to project inflation for the next FYDP, which will encompass the 1998-2003 defense program. However, in commenting on a draft of this report, DOD said that OMB has indicated its intention to adopt the chain-weighted methodology for budgeting beginning with the fiscal year 1998 submission. In addition, the President’s budget for fiscal year 1997 emphasized the limitations of the fixed-weighted methodology and featured the improved chain-weighted methodology in presenting economic assumptions for the future. If OMB uses the improved chain-weighted methodology to provide inflation guidance to DOD, DOD’s funding estimates for fiscal years 1998 and beyond could be affected. For example, on a chain-weighted basis, two major private forecasting firms currently project an inflation rate of about 2.5 percent per year over the next 5 years, which is a decline from the 2.7 percent chain-weighted inflation assumption that appears in the fiscal year 1997 budget. If OMB gives DOD an inflation projection of 2.5 percent per year for the 1998-2003 period, a question arises as to whether such a factor will be interpreted as an increase (from the 2.2 percent as measured by the fixed-weighted methodology) or a decrease (from the 2.7 percent as measured using the chain-weighted methodology.) Without further guidance, DOD may increase its estimates of future funding requirements for inflation when inflation is projected to be lower than the earlier forecast. During consideration of the fiscal year 1997 defense budget, the Chairman of the Senate Committee on the Budget requested that CBO estimate the adjustments that should be made to DOD’s budget estimates through 2002 that would keep its purchasing power constant given lower inflation rates. CBO chose not to use the implicit price deflator for GDP based on the fixed-weighted methodology that OMB had used to calculate inflation because it had been replaced by the new chain-weighted methodology. Instead, CBO based its inflation forecast on the Consumer Price Index, which measures changes in the average cost of a fixed market basket of consumer goods and services because that measure had not been revised. Neither the executive branch’s nor CBO’s estimate presumes any ability to forecast prices of goods and services purchased by DOD. Instead, the two estimates calculate the change in a general index of inflation and assume that prices of defense goods and services would change by the same amount. Using the Consumer Price Index, CBO projected a much smaller decrease in inflation between the 2 budget years than the executive branch did. Whereas the executive branch projected an 8/10 of 1 percent drop in inflation, CBO projected that inflation would drop only 2/10 of 1 percent. As a result, CBO projected that DOD’s purchasing power would increase by only about $10.3 billion for the 1997-2001 period. This estimate is about $24.4 billion less than DOD’s estimated $34.7 billion increase. Further, because the executive branch reduced DOD’s estimated 1997-2001 FYDP by about $15.2 billion, CBO’s estimate indicates that DOD’s real purchasing power was reduced by about $5 billion.