Fiscal Cliff Deal Creates Contracting Ordeal, Accounting Nightmare for Defense

The Jan. 2 budget deal — which delayed mandatory federal spending cuts until March 1 — will boost the Pentagon's 2013 coffers by $12 billion.
The law, known as the American Taxpayer Relief Act of 2012, also is creating an accounting ordeal for the Defense Department, and could set off a chaotic chain of fiscal events that would force the Pentagon to furlough its entire civilian workforce for a whole month, and cancel or renegotiate thousands of contracts, says Todd Harrison, senior analyst at the Center for Strategic and Budgetary Assessments, a nonpartisan think tank in Washington, D.C.
The legislation changed the calculation for how the automatic "sequester" would affect the Defense Department and how the cuts would be enforced in fiscal year 2013. Under the original sequester that would have gone into effect Jan. 2, the Pentagon's fiscal year 2013 budget would have been cut from $525.4 billion to $470.9 billion. Under the new measure, 2013 funding would be raised to $485.7 billion,according to CSBA’s analysis.
The Pentagon thus could end up with a 2013 budget that is $8 billion higher — in inflation-adjusted dollars — than it was in 2007. Under the previous sequester, defense spending would have dropped to the 2006 level, Harrison said Jan. 9 at a CSBA news conference.
The Jan. 2 law gives the Pentagon an additional $12 billion in fiscal year 2013 — a reprieve that is roughly in proportion to the two-month delay, says Harrison. Instead of cutting $54.7 billion over the remaining nine months of the fiscal year, $42.7 billion will be cut over seven months.
But the law did not alter the way the cuts must be administered. It still requires a uniform percentage reduction across all accounts, except military payroll. The original sequester, Harrison concludes, would have trimmed spending by 11.5 percent cross all applicable accounts. Under the amended law, the reduction is 8.8 percent.
Although the amount of the cut for defense is smaller, the delay shrinks the period over which the reductions must be applied. If sequester goes into effect March 1, the consequences would be felt immediately and most severely by Defense Department civilians and contractors.
“One of the first things we’ll see is that the Defense Department will have to start furloughing civilian employees,” says Harrison. He estimates that, to achieve the 8.8 percent target, the Pentagon would have to furlough almost its entire workforce of 791,000 civilians — whose compensation amounts to about $70 billion a year — for a whole month between March 1 and September 30, when the fiscal year would end. “You only have seven months to administer that cut,” says Harrison. “That means you have to reduce payroll expenses for the remainder of the year by 15 percent.” The alternative would be to lay off employees, an option that Pentagon officials have ruled out.
For contractors, the impact of a March 1 sequester also would be significant. Programs that already have been funded by that deadline will continue on, but over the remaining seven months of the fiscal year, every account will have less money to obligate. That means the Pentagon will have to delay contract awards, reduce orders and renegotiate purchase options with suppliers, says Harrison. That creates long-term problems, too, for the Defense Department because buying smaller quantities increases the per-unit price of weapon systems, he notes. “The long-term effect [of a March 1 sequestration] is that it will reduce the Defense Department’s purchasing power. … Not to mention it will cause all kinds of contract modifications and renegotiations, and will create a backlog of contracting work.” To add insult to injury, he points out, part of the procurement workforce might be furloughed. “This is going to be a contracting nightmare for DoD,” he says.
Major acquisition programs could be at risk of substantial cost increases, he says. Case in point is the Air Force’s KC-46A aerial refueling tanker, which The Boeing Co. is developing under a fixed-price contract. The company is absorbing losses on the program on the belief that the Pentagon will buy a certain number of aircraft, says Harrison. If quantities are reduced, the contractor might walk away from the program, he says. “This weakens the Defense Department’s negotiating position.” Sequestration, however, will not likely lead to many program terminations in the coming year, as no account is being cut to zero.
Harrison warns that while these scenarios are dire, they are manageable. “This is not the end of the world,” he says. “This is going to create a real mess for the Defense Department. But, to be clear, I don’t think this is the apocalypse. I don’t agree with the over-the-top rhetoric,” he says. “I think it forces a lot of really stupid decisions. It’s shortsighted. But we’ll survive it if it happens.”
He does criticize defense leaders for having chosen to act over the past year as if sequestration were never going to happen. “They are beginning to realize the impact pretty late in the game, quite frankly,” he says. Defense officials did not start doing detailed planning until December. “Before March 1, they should notify their civilian employees about a furlough plan.”
In anticipation of a March 1 sequester, Harrison speculates that many program managers will be seeking to game the system by obligating funds before the deadline, to ensure their projects stay alive. “Program managers have an incentive to get as much funding obligated as possible by March 1,” he says. “Once funding is obligated, it’s not subject to sequestration cuts.”
On a macro level, though, senior officials do not want program managers rushing to obligate funds because that could drain resources from other projects over the last seven months of the year.
“We did see a lot of late contract activity in November and December, heading up to the Jan. 2 sequestration deadline we just avoided,” he says. “We may see a repeat of that.”
As to whether sequester can be avoided one more time, Harrison says that would require a comprehensive budget and tax bargain that replaces the entire $1.2 trillion worth of spending cuts — half for defense and half for nondefense agencies — with reductions in entitlement programs or tax increases. Congress could also pay for sequestration by lowering future budget caps for defense by some amount, says Harrison. “There’s a lot of ways they could do it.”
But he remains skeptical that any such deal can be accomplished in such a short time. By tying the outcome of sequestration to the debt ceiling extension, Congress made it all that much more likely that the automatic cuts will happen, he says.
Republican lawmakers will insist that any extension of the debt ceiling will have to be offset by spending cuts. Increasing the debt ceiling enough to give the government a year's worth of operating expenses requires about a trillion dollars, says Harrison. Another trillion dollars will be needed to pay for sequestration. “Putting these two on the same timeline doubles the problem,” he says. “I’m not confident that Congress can come up with another $2 trillion in deficit reduction by that deadline.”
As a result, the odds of sequestration going into effect now have gone up. Another punt is still a possibility, says Harrison. “At some point, though, the delays run out and you have to do something."
The two-month postponement that Congress approved Jan. 2 has created a confluence of three critical fiscal events scheduled to occur in or around the month of March.
• First, the Treasury will begin to run out of options to avoid breaching the debt ceiling in late February or early March. If Congress does not take action to raise the debt ceiling, the Treasury will not be able to pay all of the nation’s legal obligations, which include payments to military personnel, defense civilian personnel, and defense contractors. This has national security implications, says Harrison. “All major wars the United States has fought, from the Revolutionary War to the most recent wars in Iraq and Afghanistan, have been financed in part through borrowing.”
• The second event is sequestration, which would occur on March 1 and again on March 27 (the after-session sequester) when government funding for fiscal year 2013 is scheduled to run out.
• The third critical fiscal event also occurs on March 27 when the current continuing resolution expires. If Congress has not passed an appropriations bill or continuing resolution by that date, the federal government will have to shut down all non-essential activities.
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