The Department of Defense is trying to reduce the costs of its infrastructure, including its commissaries and exchanges, in order to free up the funds needed to buy new weapon systems. In the case of those retail activities, however, DoD is restricting its initiatives to ones that would reduce the budgetary costs of the activities without fundamentally changing either their scope or the benefits they offer to patrons. Many factors explain that focus, including the department's desire to preserve military tradition, protect a unique and cohesive military lifestyle, and keep faith with current military retirees.

But in the post-Cold War era, DoD's retail system faces some fundamental questions that go beyond ways to reduce costs. Those questions deal with the purpose of the system and the nature of the benefits it provides. Should DoD's stores target retirees and reservists, or should they focus more on providing goods to service members stationed overseas? Should the Congress help maintain commissary and exchange sales in the United States by extending shopping privileges to new groups of patrons or authorizing the stores to sell a wider range of goods and services? Should the military's ability to support morale, welfare, and recreation programs depend on profits made by selling alcohol and tobacco? This might be an appropriate time for DoD to reassess its role and consider options that would focus its retail activities on needs that are not met by private businesses.

Yet the department has little incentive to seek fundamental changes in its retail role. One of the most important factors underlying the growth and persistence of DoD's commissary and exchange systems is the fact that most of their costs fall outside the defense budget. By operating an extensive array of retail activities, the department is able to use its federal immunity from state and local taxation and its access to interest-free capital to capture resources that do not appear in its budget.

This chapter examines four alternatives for the future of DoD's retail activities (see Table 8). The first two, which focus on reducing budgetary costs, would encourage the department to maintain a large retail role. Alternative 1, the department's current plan, would reduce costs to DoD by consolidating the three separate exchange systems and by giving managers of the Defense Commissary Agency more freedom under the performance-based organization concept. Some observers view that plan as a step toward Alternative 2: the creation of a single organization (what DoD refers to as a resale authority) that would provide groceries, general merchandise, and consumer services at all military bases with minimum use of appropriated funds.
 

Alternatives 3 and 4, in contrast, would make DoD recognize the social costs of its retail activities, thus encouraging the department to limit their size and focus. Alternative 3 would do that by requiring DoD to rely on private contractors rather than in-house activities. Because private contractors pay sales tax and earn a market return on their capital, that alternative would shift much of the social cost of on-base retail activities into DoD's budget. The fourth alternative would make the social costs of those activities visible by requiring commissaries and exchanges to make tax payments and to borrow capital at the private, pretax rate of return.
 

Alternative 1: Follow DoD's Current Plan

As part of its plan to maintain the benefits but reduce the costs of its retail activities, the Department of Defense is examining ways to merge the three exchange systems (the Army and Air Force Exchange Service, the Navy Exchange Command, and the Marine Corps exchanges). It is also seeking waivers and legislation that would give DeCA's managers greater freedom to manage resources.

Reducing Costs in the Exchange System

Although some type of exchange consolidation appears to be part of DoD's current strategy, its extent and form have not been determined. Options for consolidation range from integrating the three systems' overhead functions (such as distribution systems and purchasing offices) to completely merging the three into a single organization. However, concern among the individual services about what effect consolidation would have on exchange operations and the distribution of exchange earnings could forestall any action. Although the Assistant Secretary of Defense for Force Management Policy initially announced that consolidation was to be complete by December 1998, the question of consolidation is still being studied and debated within DoD today.⁽¹⁾ For the purposes of this analysis, Alternative 1 assumes that the department's final plan will call for consolidating the three exchange systems into a single organization.

Such an initiative would almost certainly generate savings for DoD as a whole. But the savings would be relatively modest compared with the total cost of the exchange system. Because NEXCOM, AAFES, and Marine Corps exchanges do not operate on the same military installations, even completely integrating the three systems could have little impact on operating costs at the store level.

The exact amount that consolidation would save is uncertain. In 1990, a DoD study group (Jones II) concluded that savings from a single exchange system would total approximately million a year.⁽²⁾ The savings would come primarily from reducing headquarters overhead and eliminating duplicative systems for personnel, buying, warehousing, transportation, and automated information. That estimate could still be realistic today. It equals about 7 percent of the 1995 operating costs of Navy and Marine Corps exchanges, or about 40 percent of their headquarters, regional, and distribution costs. Because AAFES already accounts for 70 percent of total exchange sales, its headquarters and support activities might, with modest increases in resources, be able to support the stores now operated by NEXCOM and the Marine Corps.

Other estimates of savings, however, vary widely. A December 1996 study for the Office of the Secretary of Defense suggested that exchange integration could save million a year.⁽³⁾ By contrast, recent internal estimates by NEXCOM indicated that annual savings could be as low as million. In today's environment of reduced exchange sales and earnings, however, even modest savings may look attractive.

One argument against a combined exchange is that it might not be as responsive to the diverse needs of service members as the individual exchange systems are. Another concern is that exchange operations might be disrupted during the transition. A more fundamental criticism, however, is that DoD's plan would do nothing to shift the focus of the exchange systems away from generating illusory nonappropriated-fund earnings in competition with U.S. retailers and toward meeting needs (such as those of service members overseas) that U.S. retailers cannot meet.

Reducing Costs in the Commissary System

DoD plans to cut the overall cost of its commissary system (while maintaining the benefits) by using policy waivers and legislation that will give the system's officials the freedom to manage resources more effectively. The Administration signaled its support of that effort by designating DeCA a performance-based organization in October 1996. Managers of PBOs are meant to have greater authority and accountability than managers of other federal agencies. DeCA's designation as a PBO is largely symbolic, however. The effectiveness of the initiative will depend on the specific waivers and legislation that the agency ultimately obtains.

Policy and Legal Constraints on DeCA Management. DeCA currently operates under constraints that limit its ability to control labor costs, acquire goods and services at the lowest cost, and allocate its funds efficiently. Although some of those constraints are legal ones that arise because DeCA is a government agency, others are policy constraints imposed by DoD or other executive branch agencies.

As members of the federal civil service, DeCA's employees are subject to civil service rules on hiring, pay, promotion, and retirement. Salary and benefits for DeCA employees, many of whom are cashiers, average ,000 a year. That amount is roughly 1.5 times the average ,000 in salary and benefits received by employees of commercial supermarkets.⁽⁴⁾ According to DoD estimates, it is also 1.5 times the average cost of similarly skilled exchange workers (who, as NAF employees, are not part of the civil service). If DeCA could lower its personnel costs to private-sector levels, it would save more than million a year.⁽⁵⁾

DeCA tries to avoid paying civil service salaries for its store-level labor by relying heavily on contractors. Its use of contract workers to stock shelves, for example, has led to reported savings of 40 percent.⁽⁶⁾ Nonetheless, contractors working for DeCA are subject to the Services Contract Act, which requires them to pay higher wages than they might otherwise. Moreover, in selecting contractors, DeCA is subject to the provisions of the Small Business Act and the Javits-Wagner-O'Day Act (which give preference, respectively, to small businesses and to contractors who hire blind or severely disabled workers). The high cost of civil service personnel and those restrictions on direct contracting have encouraged DeCA to rely on its vendors for some labor services that civilian grocers find it more cost-effective to perform in-house.

Although DeCA does not have to follow standard federal acquisition rules when it buys brand-name goods for resale, it is legally bound to do so when it buys non-brand-name goods or equipment and supplies to be used in commissaries. Other constraints that the agency faces in purchasing goods and services result from DoD policy. They include requirements to use the Defense Finance and Accounting Service for bill paying and bookkeeping, the Defense Logistics Agency for personnel services, and DoD's telecommunications services.

DeCA's managers are also limited in their ability to generate and spend revenue to support commissary operations. Although the agency's appropriation is not large enough to keep commissaries open for all of the hours that customers want service, DoD policies restrict DeCA's efforts to raise additional revenue by selling advertising and other services to its vendors. Moreover, funds from the 5 percent surcharge that DeCA levies on sales are kept in a separate account from appropriated funds and can be used only to build stores or buy supplies and equipment. As a result, the agency sometimes builds a large store that will operate for a limited number of hours rather than a smaller store that might operate for more hours.

The Ideal Performance-Based Organization. An ideal PBO initiative might revoke those constraints and give DeCA the same freedom to manage resources that private companies have. Supporters of the PBO concept within DoD argue that a performance-based system would also provide incentives for managers and employees to use that freedom to reduce costs. In their view, DoD's in-house stores could reap the same savings that would be offered by outsourcing (contracting with private firms to provide commissaries) but without the costs of negotiating and monitoring contracts and the risks imposed by contractual relationships. Although DeCA, even as a PBO, would lack the in-house regional distribution networks that support most large chains of grocery stores, it could rely on the commercial networks that independent grocery stores use.

If DeCA carried out the PBO concept aggressively, its potential savings could be significant. Because the agency spends $1.4 billion a year on operating costs, a 10 percent to 20 percent reduction in such costs would yield savings of million to million a year. Based on the more than 30 percent difference between the average hourly wages of civil service and non-civil service retail labor, million could be a conservative estimate of the potential savings.

Actual Savings from a PBO. For a number of reasons, the PBO approach is unlikely to achieve all of those potential savings. One reason is that DeCA might not get all of the waivers and legislation that it requests. Another is that DoD has chosen not to pursue some of the more ambitious PBO proposals because of the overwhelming obstacles it would face in trying to get the necessary waivers and legislation. For instance, it does not plan to request exemption from the Services Contract Act or the Davis-Bacon Act, both of which affect the wages that contractors working for DeCA must pay. Rather than convert its entire labor force to NAF status, DeCA may focus only on newly hired store personnel who do not have supervisory jobs. (Because of the importance of labor costs, however, even that more modest change could have a significant impact on DeCA's costs.)

Perhaps the most important weakness in the PBO approach is that although it attempts to give DeCA managers the same freedom enjoyed by managers in the private sector, it does not subject them to the incentives and constraints that competition imposes on the private sector. As long as DeCA remains a subsidized monopoly, its managers will not have the same performance incentives as managers of private stores. DeCA's survival depends not on profitability but on the ability of its senior officials to maintain political support within DoD, the Congress, and private industry. That may mean continuing to operate small stores in locations where there are few active-duty personnel, continuing to stock only brand-name rather than less costly private-label products, or continuing to purchase soda overseas from the military exchanges rather than private suppliers. Without the pressures of competition, the ability to pay higher salaries to senior DeCA officials may not change the quality of management.

Another risk of the PBO initiative is that because of the incentives facing DeCA officials, some of their requests for waivers and legislation may be aimed less at improving the management of commissaries than at reducing the visibility of taxpayers' support. For example, DeCA might request that the Congress authorize DoD to provide utilities without charge in overseas locations (as DoD does for exchanges) or that the Congress require the Treasury to pay DeCA interest on its surcharge balances. Although both proposals would lower the agency's need for appropriations, neither would result in any federal budgetary savings. (In fact, freeing DeCA from the cost of overseas utilities might result in less careful use of resources and thus increase federal budgetary costs.)

Similarly, proposals that would exempt DeCA from the requirement to rely on DoD personnel, finance, and telecommunications systems might simply shift costs to other DoD customers.⁽⁷⁾ Other proposals, such as allowing DeCA to enter into long-term leases for buildings provided by private contractors, might reduce the need for appropriations in the short run but increase it over the long run. Still other proposals, such as extending commissary benefits to DeCA employees, could shift part of the cost of commissary operations to state and local governments, which would lose sales tax revenue as those employees spent less money in commercial supermarkets.

Even if DeCA managers used their freedom to operate in a businesslike manner, the result might not be desirable in an enterprise that depends on direct and indirect taxpayer support. For example, increasing sales to retirees and reservists is a businesslike response to the recent decline in the number of active-duty personnel. Yet those additional sales would impose costs on taxpayers (including taxpayers at the state and local levels) even though the new patrons might have virtually no preference between commissaries and civilian supermarkets located near their homes. Rewarding managers for increased sales might also encourage black-market sales overseas and unauthorized use of commissaries in this country. Giving DeCA the ability to reward managers who increase sales, or the ability to generate revenue that would allow it to operate more stores for longer hours, are aspects of the PBO initiative that appear businesslike but could have unintended consequences for taxpayers.

Excusing DeCA managers from the rules that safeguard the behavior of most public agencies also introduces risks. For example, the legislation that permits DeCA to treat its baggers as independent contractors has helped control the agency's need for appropriations. But it has also left 10,000 workers who are in effect federal employees (people who work in commissaries, using commissary equipment, under the supervision of store managers) unprotected by minimum-wage or workers' compensation laws. Would a PBO abuse its right to grant bonuses to executives? Would it continue to rely on open and fair competition in procurement? Would it continue to support the social goals embodied in the Small Business Act or the Javits-Wagner-O'Day Act?

Because the PBO umbrella is wide enough to encompass changes that would increase costs as well as those that would decrease costs, each waiver or change in legislation proposed as part of DeCA's PBO initiative needs to be evaluated on its own merits. Moreover, the very need to create a unique, untested performance-based organization--operating under different rules than other DoD agencies or private firms--raises questions. If commissaries need more freedom to operate like private businesses, why not allow private firms to run them under government contract? Most government corporations have had some rationale for their federal status (at least historically) based on special market conditions that did not permit private firms to compete effectively. But the provision of groceries is clearly an area in which private firms and competition have proved successful. Finally, if an in-house retail system is desirable despite those concerns, why must there be both a NAF model for exchanges and a PBO model for commissaries? Might not the same organizational structure--or the same organization--suffice for both types of retail activities?
 

Alternative 2: Create a DoD Resale Authority

Another way the Congress could reduce the budgetary costs of DoD's retail activities would be to consolidate commissaries and exchanges into a single NAF-like organization, commonly referred to as a resale authority. That approach offers the greatest budgetary savings for the department. If the resale authority charged exchange prices for all goods (including food), this alternative could eliminate the need for appropriations to support DoD retail activities at bases in the United States.

To some extent, Alternative 2 is a logical extension of initiatives that are already under way. For instance, provisions in the 1996 defense authorization act encourage greater integration of exchange and commissary operations by allowing DeCA and the NAF activities to buy support services from each other if that will reduce costs.⁽⁸⁾ Moreover, DoD's PBO initiative and its moves to consolidate the three exchange systems could be seen as steps toward eventually integrating a NAF-like PBO with a single NAF exchange system.

The Benefits of a Resale Authority

By consolidating exchanges with commissaries, DoD would achieve many of the same types of savings that it would by merging the exchange systems--including savings from shared distribution, warehouse, transportation, personnel, and information systems. In particular, consolidating the separate warehouse and distribution systems used by DeCA and the exchanges overseas could offer significant savings.

Consolidation also might offer large savings at the store level. Military installations typically house both a commissary and an exchange, frequently in adjoining buildings. Combining those stores would be a particular advantage for DoD in locations that cannot support separate stores efficiently. In fact, a number of small combined stores are already operating overseas under the auspices of NEXCOM, AAFES, or DeCA.

Even in locations served by larger stores, combining commissaries and exchanges could offer patrons the convenience of a wider range of goods and services under one roof. In the private sector, "hypermarts" are increasingly popular. They are large stores that sell both groceries and general merchandise and also offer a wide range of services such as prescription drugs, banking, and video rental. Combining exchanges and commissaries would allow DoD stores to look more like those in the private sector. (The transition to large, physically combined stores would be very gradual, of course, because it would depend on the construction of new facilities.)

In addition, converting all DeCA employees to NAF status might provide more flexibility and generate greater savings in labor costs than a PBO approach that maintained civil service status for supervisors and managers.

Pricing Strategies Under a Resale Authority

Conceptually, a DoD resale authority could offer patrons equal or greater savings than the current system of commissaries and exchanges does. Nonetheless, one reason the Department of Defense might be unwilling to pursue this alternative is that forming a single resale authority could lead to higher prices on commissary items and reduced benefits for patrons.

Although commissaries apply a uniform 5 percent markup to all goods, exchanges (like commercial retailers) apply different markups to different goods. Integrating the two systems into a single businesslike resale agency might eventually lead to variable markups for food as well. Of course, the Congress could provide the same level of appropriations to a resale authority that used variable markups as it now does to commissaries. Yet once the principle of selling goods at the wholesale cost plus a 5 percent markup was lost, there might be no logical basis for determining what the appropriation--if any--should be. Any number of pricing strategies exist that would reduce the need for appropriations and still permit DoD to provide access to on-base shopping.

The Carswell Pricing Model. Today, DoD is experimenting with combined exchange and commissary operations at two U.S. bases (Carswell and Homestead) that were recently closed. At those bases, commissary food items are sold at the usual 5 percent markup, but nonfood items (such as paper goods, toiletries, and cleaning supplies) are sold at the higher (and variable) exchange markups. The Carswell pricing model would be an obvious alternative for a DoD resale authority operating combined commissary/exchange stores.

Nonfood items account for 28 percent of commissary sales: 9 percent are tobacco products, and 19 percent are other nonfood items. As of last year, tobacco is already sold in commissaries at exchange prices. Raising the price on other nonfood items to exchange levels--an average increase of 20 percent--would generate approximately million a year in additional revenue.⁽⁹⁾ About million of that, however, might be used to raise cost-of-living allowances for overseas personnel by enough to offset the price increases. If so, net budgetary savings would total about million a year.

Raise Average Food Prices by 10 Percent. Another way a DoD resale authority might reduce its need for appropriations would be to make its pricing policies for food items more consistent with those for nonfood items. For example, it might introduce variable markups for food and raise the average price by 10 percent. The revenue generated by that price increase would permit DoD to reduce annual commissary (or resale authority) appropriations by million while also providing million in additional COLAs to offset the price increases for overseas personnel.

If commissaries currently offer savings of 20 percent relative to commercial prices (as CBO estimates), a 10 percent price rise would result in commissary prices that were 12 percent below commercial levels on average, taking into account both surcharges and sales taxes. That figure may be comparable with, or slightly more than, the average savings that DoD exchanges offer today.

If, instead, commissaries currently offer savings of 29 percent (DeCA's most recent estimate), a 10 percent price rise would leave commissary prices on food items 20 percent below commercial levels. That is equal to the goal set by exchanges for their items and is only 3 percentage points below the savings of 23 percent that DeCA reported in 1991. In addition, in the late 1940s, when the current commissary system was being established, 20 percent was the average markup in civilian grocery stores and thus the level of savings that a commissary selling at wholesale cost might have been expected to provide.

A 10 percent price increase would also make sales of food items a more cost-effective benefit. The only people who would stop shopping for groceries on-base or reduce their purchases because of the price increase would be those for whom the benefit from the forgone purchases (including the benefit from shopping in an exclusively military environment) did not justify the additional 10 percent payment. CBO estimates that a $1 decrease in commissary sales would reduce operating costs by 13 cents and forgone taxes by 5 cents (see Appendix C).⁽¹⁰⁾ Thus, any sales that are lost because of a 10 percent price rise are sales for which the costs outweigh the benefits that patrons receive. If the opponents of price increases are correct when they argue that even modest increases would dramatically reduce commissary sales, that is evidence that the benefits from many sales--in the view of DoD customers--are less than the costs of the subsidy.

Charging exchange prices for nonfood items and raising the prices of food items by 10 percent would save DoD about million a year in appropriations for the combined resale authority (see Table 9). Because the prices of both food and nonfood items would remain below commercial levels, active-duty service members and retirees who now shop at commissaries and exchanges might still receive a significant benefit. And although this pricing strategy would reduce sales, those lost sales would be ones that were clearly not cost-effective to make in the first place. The more valuable commissaries were to patrons, the smaller would be the impact on sales. Commissary and exchange benefits could continue to be regarded as an integral feature of military life.
 

The pricing options described above could actually improve the welfare of U.S. military families overseas. The increase in overseas COLAs would fully compensate them for the price rise. Thus, if they chose to, service members could continue to buy the same quantity of goods from their commissaries. But because the large price differential that now exists between commissaries and local stores overseas would be lessened, overseas families might have a wider array of affordable options than they do today.

One major disadvantage of those pricing proposals is that they would reduce the benefits provided to current and former military personnel in the United States, many of whom feel that they have earned the right to buy commissary products at the 5 percent markup. In the United States, DoD could compensate active-duty service members as a whole for the higher food prices they would face by adding million annually to the basic allowance for subsistence, or BAS.⁽¹¹⁾ (That would equal about more a year for each active-duty member who receives the allowance). An increase of million annually would compensate active-duty personnel for the increases in both food and nonfood prices. However, there would be no practical way to compensate retirees for the price increases or to fully compensate those active-duty personnel who rely most heavily on DoD commissaries.

Creating a single DoD resale authority would not necessarily require changing commissary prices or shifting commissary workers to NAF status. Likewise, the Congress could authorize a commissary PBO to adopt the pricing options outlined in Table 9 without creating a unified resale authority. Nonetheless, the creation of such an authority and the integration of exchange and commissary stores would make changes like those more likely. As a result, people who wish to preserve the commissaries' 5 percent markup and civil service labor force might not find a DoD resale authority an attractive option.

Maintaining the Accountability of In-House Retail Activities

The Congressional Budget Office's review of NAF exchange operations suggests some steps that might keep a unified resale authority accountable to DoD and the Congress. Although those steps apply to an authority that would include commissaries and exchanges, they could also be used to establish better accountability for the three separate exchange systems, a consolidated exchange system, or other NAF morale, welfare, and recreation activities.

One step would be for the Congress to enact enabling legislation that would acknowledge the federal status of the DoD resale authority, spell out its powers and responsibilities, and incorporate it into the federal budget. The resale authority could be organized either as a DoD revolving fund with the status of a PBO or as a separate government corporation. In either case, it could be granted the same freedom that exchanges enjoy as NAF activities. In the enabling legislation, the Congress would authorize the fund or corporation to spend receipts from its sales to cover its operating costs on a revolving basis. To ensure Congressional control over discretionary spending, however, the fund would require specific Congressional authorization before it could spend its earnings to support DoD's MWR or quality-of-life programs.⁽¹²⁾

Putting DoD's NAF retail activities into the budget would make their treatment consistent with the principles established by the President's Commission on Budget Concepts in 1967 and provide a better picture of the total level of federal resources. Such a change would have no effect on total federal outlays or the deficit in those years when, under the current system, NAF receipts matched NAF expenditures. In years when spending exceeded receipts, federal outlays would rise by the difference; in years when spending was less than receipts, federal outlays would fall.

Alternative 2 would create savings by giving managers better visibility of and control over their use of resources. A single revolving-fund or corporation budget would account for all of the operating costs of the resale authority, both those now paid with appropriated funds and those paid with nonappropriated funds. Under the current setup, the exchange systems' statements of NAF income and expenses do not show appropriated funds used to support exchanges (including funds for overseas transportation and utilities, and the cost of base support services such as police and fire protection and exterior building maintenance). As a result, the managers who operate AAFES's overseas bakery, ice cream production line, and meat-processing line do not take into account their utility costs or the cost of transporting raw materials from the United States. The separation of appropriated funds from nonappropriated funds may have encouraged the exchanges to spend over million in 1995 transporting beer and soda overseas rather than seek local suppliers.⁽¹³⁾

This budgetary treatment would also eliminate the process by which appropriated-fund support provided to exchanges generates illusory NAF earnings that are spent outside the budget process. The resale authority would rely on receipts from patrons to reimburse DoD for the cost of any services the department provided. In 1995, those costs for military exchanges were slightly greater than the exchanges' total NAF earnings.

The Budgetary Impact of a Resale Authority

The total budgetary savings provided by Alternative 2 depend on many factors. Those factors include savings from converting commissary employees to NAF-like status, savings from consolidating stores and headquarters, increased revenue from higher prices on commissary items, and the reimbursement of appropriated-fund support provided by DoD to the exchanges. Those gains would be partially offset by increased requirements for overseas COLAs and appropriated-fund support for MWR activities. Although the overall impact of those factors is uncertain, this alternative could save DoD as much as million to $1 billion a year in appropriated funds. That estimate takes into account the cost of raising appropriations to offset the loss in NAF dividends for Category A and B morale, welfare, and recreation activities. Of the four alternatives that CBO examines in this study, the resale authority would offer DoD the greatest budgetary savings.

The Risks and Limitations of a Resale Authority

Despite the potential for large budgetary savings, this alternative would entail some risks. One is that MWR programs would suffer from the decline in exchange earnings. Rather than relying on NAF earnings, the Congress would have to appropriate funds to support those programs. Although doing so would permit the Congress to limit the level of resources used to subsidize Category C activities such as hotels and clubs, it would also introduce a risk that the Congress might not provide support for the Category A and B activities that DoD considers essential. (CBO estimates that the Congress might have to appropriate as much as an additional million a year to Category A and B activities to offset lost exchange earnings.) Another risk is that a resale authority forced to pay the cost of overseas transportation and utilities might not continue to provide the same level of support to service members overseas.⁽¹⁴⁾

An additional problem is that a DoD resale authority with immunity from state and local taxes and access to interest-free capital would not compete with off-base merchants on a level playing field. As a result, it might not be driven to control operating costs in the same way as private retailers. Without effective competition, an in-house enterprise may fail to minimize its operating costs even if it is given all of the freedom that private firms have to set prices and manage resources.

Moreover, a resale authority of this type leaves unresolved some important questions about the nature and extent of DoD's role in retail activities. Even though the resale authority might not receive large appropriations, total taxpayer support in terms of forgone taxes and forgone return on capital would be substantial. (In 1995, forgone taxes and return on capital for commissaries and exchanges in the United States totaled more than $1.4 billion, or about 12 percent of sales.) Because discount retailers and supermarkets operate on narrow margins, that subsidy might encourage DoD to continue running a large in-house retail system that would attract shoppers from off-base. In order to limit the need for appropriations, a DoD resale authority might continue to sell tobacco and alcohol at low prices and to target retirees by offering upscale merchandise. And in the absence of large annual appropriations, there would be little opportunity to debate the costs and benefits of that system.

Alternative strategies that would change the focus and scope of DoD's retail role are those, such as Alternatives 3 and 4 below, that emphasize the social rather than the budgetary costs of DoD's activities.
 

Alternative 3: Rely on Private Contractors

This alternative would require DoD to contract out for retail activities at military bases. Some proponents of this approach argue that it would reduce DoD's budgetary costs without reducing the benefits provided by on-base stores. According to a 1996 report by the Defense Science Board, commissaries operated by private grocery chains under DoD contracts could provide the same benefits as today's commissaries at an annual savings of million to million.⁽¹⁵⁾ In its analysis, CBO reached a different conclusion: although contracting offers many advantages that could reduce social costs, it would shift more of those costs into the defense budget and thus might not be an appealing option from DoD's budgetary perspective.

Some Advantages of Contracting for Retail Activities

Contracting avoids many of the problems associated with the current NAF system for exchanges, the PBO initiative for commissaries, or a DoD resale authority. Contractors would collect the billion that patrons now spend at DoD-operated exchanges and commissaries and would pay the expenses of those operations. Only a small portion of that money--in the form of concession fees paid to DoD--would come directly under the control of federal employees. Those fees might enter the budget as offsetting receipts.

If DoD relied on contractors, there would be no need for unique personnel or accounting systems designed to provide in-house enterprises with enough freedom to minimize costs while still ensuring adequate control of federal resources. Contracting would automatically achieve the savings possible by freeing DeCA from civil service constraints, federal acquisition rules, and the requirement that it use DoD services for transportation, printing, and accounting. Regional contracts with large general-retail merchandisers would eliminate the cost to DoD of maintaining a warehouse and distribution system to serve stores scattered throughout much of the world.

Most important, the use of contractors would introduce competition. Past studies of commercial activities performed by public and private enterprises suggest that competition can have a dramatic effect on costs. In addition, using a formal competitive process to award contracts might safeguard the contractor from the political pressure that vendors, or potential vendors, might bring to bear. In-house DoD activities, which depend directly on Congressional appropriations, can be in a vulnerable position when powerful industry groups seek to have them provide particular goods (such as U.S.-bottled soda in overseas locations) or exclude particular goods (such as private-label merchandise in commissaries).

Because DoD exchanges have experience using concessionaires to provide some goods and services at military bases, Alternative 3 is less risky than it might appear. Such contractors already account for 8 percent of total exchange sales and 36 percent of exchange earnings. Some of the contracts--including those for pay-telephone services, McDonald's franchises at Navy bases, and optical services for AAFES--are negotiated at exchange headquarters on a worldwide basis. Others, such as for florists, barbershops, and espresso stands, are negotiated with contractors that may serve only a single base or region. In both cases, contractors are required to meet specific performance standards and make payments--usually on the order of 20 percent of gross sales--to the exchange system. Unlike the managers of DoD's in-house operations, concessionaires face periodic competition when their contracts expire.

This option would greatly expand the scope of activities that were contracted out, however. Although concessionaires already provide many consumer services, DoD does not use them to operate main retail stores, liquor stores, or commissaries. Another difference between this option and DoD's current use of concessionaires is that if price increases were not permitted, the contracts for operating commissaries and many retail stores would require payments from DoD to the contractor rather than concession fees paid by the contractor to DoD.

Some Potential Limitations of Contracting

A policy of relying on contractors would not entirely eliminate DoD's involvement in retail activities. The department would be active in setting policies, writing contracts, selecting contractors, and monitoring performance. In addition, DoD might still have to plan and pay for constructing on-base facilities. Although in the past some concessionaires with 10-year contracts have risked constructing small buildings on military bases, the level of guarantees that would be necessary to make large construction projects on government land attractive to private firms might result in what was, in effect, government construction. Moreover, a contract period that was long enough to allow private firms to recoup a major investment such as construction would reduce the effectiveness of competition.

Contract Costs. Because of the costs of negotiating and monitoring contracts, it is sometimes more cost-effective to keep activities in-house even when a contractor can carry them out more cheaply. Predicting what such negotiating and monitoring costs would be for DoD retail operations is difficult. But if the cost of monitoring base-support contracts is a guide, they might well equal 10 percent of the contractors' operating costs, or perhaps 2 percent to 3 percent of total sales.⁽¹⁶⁾ In the context of billion in annual commissary and exchange sales, those costs would be significant.

The need to monitor contractors would be greatest for activities, such as commissaries, that received subsidies from DoD in order to sell goods at prices well below the market level. Those contractors might try to generate profits by reducing the quality of their service. Contractors that operated on-base retail stores in the United States in competition with discount stores would require limited monitoring, since they could not reduce the quality or selection of their merchandise without losing sales.

The exchanges' favorable experience with concessionaires is one indication that contracting costs may not be prohibitive for retail activities. As a percentage of sales, it could cost less to contract for large retail stores than for the services that concessionaires now provide. DoD could use regional contracts to limit the number and cost of contract negotiations. That approach would allow DoD to take advantage of the regional warehousing and distribution capabilities of private grocers and general retailers. At the same time, it could encourage competition as grocers or retailers with one regional contract tried to outperform other contractors.

DeCA already relies on contracts for many store-level services, including shelf stocking, custodial services, and in-store delis and bakeries. Contracts for each service must be negotiated separately, and commissary managers must monitor the performance of each contractor. Having a single regional contract with a private grocer that used its own employees to provide most of those store-level services might actually reduce DeCA's total cost of negotiating and monitoring contracts.

Places Where Contracting Might Prove Difficult. Some analysts argue that private firms would "cherry pick" and be unwilling to operate DoD's smaller, more isolated stores. That concern may not be realistic, however. DoD has already been very successful in getting contractor support for its small stores. For example, it relies on vendors (and distributors paid by vendors) to provide daily deliveries of goods to small stores, just as the exchanges rely on their worldwide phone contracts to provide pay-telephone service for deployed personnel in Bosnia as well as at large U.S. bases. If contracting was expanded, regional contracts that bundled profitable and unprofitable stores together would be one way to forestall "cherry picking." Alternatively, contracts to operate smaller, more costly stores could require smaller concession fees (or provide larger DoD subsidies). To encourage responsiveness to the department's needs, the contracts might permit DoD to make discretionary awards to the contractor as well as payments based on a percentage of sales.

A more serious problem might be the need to negotiate agreements with foreign countries that would permit DoD contractors to provide goods to service members overseas without paying import duties or value-added taxes. In addition, existing agreements between the United States and foreign governments that require overseas commissaries and exchanges to use local citizens in some jobs might need to be modified to cover DoD contractors. How difficult those negotiations would be is unclear. The exchange systems have already arranged with several European nations to permit some private, off-base gas stations to provide tax-free gasoline to service members. The extent to which exchange and commissary activities are concentrated in a few countries--Germany, Great Britain, Japan, South Korea, and Italy--could aid in negotiations. Where necessary, arrangements might be made for the U.S. government to hold title to the goods that the contractor would sell.

If DoD opted for greater reliance on contractors, a reasonable approach would be to apply it first in the United States, perhaps on a regional basis. Yet as DoD reduced the scope of its U.S. retail operations, the potential savings from contracting out overseas stores might increase. A recent analysis by Standard & Poor's noted that the goods sold by retailers are increasingly global in source and that, in the future, retail chains may also be global in scope.⁽¹⁷⁾ The expertise needed to operate U.S.-style stores could be provided overseas either by U.S. grocery and retail firms or by international firms. Several of the largest grocery chains in the United States, including A&P and Giant, are primarily owned by European companies. In addition, many aspects of overseas commissary operations--such as running in-store delis and bakeries--are already contracted out. Because contractors frequently handle shipping, warehousing, overseas distribution, and shelf stocking of commissary goods, DeCA employees may not touch the goods sold in overseas stores until they go over the scanner at the cash register. Although many overseas stores are small, that may not be an obstacle to contracting them out. The difference between DoD and private-sector costs may be greatest at such stores, where flexibility in the use of employees is important.

Secondary Goals. Another potential problem is that contractors might fail to pursue all of the goals that exchanges do. Compared with government enterprises, contractors might provide less support to small businesses, hire fewer workers with disabilities, and not provide workers with the same level of health care and retirement benefits. If DoD chose to, however, it could write those goals into its contracts. In addition, DoD could require contractors to give priority to military family members seeking jobs, or it might set specific goals for the percentage of family members employed.

The Budgetary Cost of Contracting

Although contracting out exchange and commissary operations appears feasible, the transition to a contractor-run system would disrupt ongoing retail activities and impose costs on DoD--including the cost of terminating DeCA's civil service labor force and the exchanges' NAF labor force. Paying those costs would be worthwhile to DoD only if it could count on significant long-term savings from using contractors. One major impediment to contracting is that although it would be likely to produce significant savings, much of the savings would not appear in the DoD or even the federal budget.

Under current law, contractors that provide retail services on military bases must pay sales taxes, excise taxes, and income taxes (see Box 7). Over the long run, they must also earn a market rate of return on their capital. If contractors operated on-base commissaries and exchanges in the United States and sold the same mix of goods that DoD sells now, those costs would be around $1.4 billion a year.⁽¹⁸⁾ By comparison, annual operating costs for U.S. commissaries and exchanges appear to be about .6 billion, based on DoD and NAF budgets. Even if competition among contractors could reduce operating costs for on-base activities by 20 percent to 30 percent, contracting is unlikely to be an attractive alternative for DoD as long as its budget reflects the full cost of contractor-run operations but not the full cost of its own retail activities. For many activities, the amount of appropriated-fund support that DoD's stores receive is much less than the subsidies that DoD would have to pay to induce contractors (given their current tax treatment) to provide the same services at the same prices.
 

Effects on the Scope of On-Base Retail Activities

Using contractors to provide commissary and exchange operations would not necessarily change the scope of DoD's retail activities. If it chose to, the department could offer subsidies to contractors that would enable large retail and liquor stores on military bases to continue providing low prices and attracting patrons from off-base. Contractors could sell the same goods and services at the same prices as DoD's current in-house activities. The estimates for Alternative 3 shown in Table 8 assume that would be the case.

Nonetheless, once the full cost of the subsidies provided to on-base retail activities became visible in DoD's budget, the department might no longer view subsidized prices as a cost-effective form of compensation. Although the changes shown for Alternative 3 in Table 8 do not reflect it, contracting out would almost certainly result in higher prices for many goods at DoD's U.S. stores and a corresponding reduction in the scale and scope of DoD's retail activities in the United States. The impact might be greatest on those activities--main retail stores, liquor and tobacco sales--that benefit the most from DoD's immunity from state and local taxation. The contractors' need to earn a market rate of return on capital would also reduce DoD's involvement in financial investments that now benefit from access to "free" capital.

Activities that depend on their proximity to people living and working on-base (convenience stores and services such as stand-alone fast food, pay telephones, and barbershops) would be less affected, although their sales might decline as the main retail stores attracted fewer patrons. Many of those convenience-oriented service activities are already handled under concession contracts. DoD's current practice of using contractors primarily to provide services rather than to operate retail stores may be explained in part by the fact that sales taxes and the cost of capital are more important factors for retail stores. In service activities, the value added is a high percentage of the sales price, and there is no need to carry expensive inventories.

Contracting out commissary and exchange activities rather than operating them in-house would shift costs that are now outside the defense budget into that budget, reducing social costs while increasing DoD's budgetary costs. Thus, even though competition can lower total social costs, the likely outcome under a strategy that relied on contracting would be higher prices and a reduced scope for on-base retail activities in the United States. In order to retain a high-quality force in that environment, DoD might need to offer additional cash compensation, as Alternative 4 envisions.
 

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. However, the department would remain free to choose between in-house and contractor operations. It would also be free to determine which activities it would subsidize and to what extent. Facing the full costs of providing subsidized, on-base retail activities would give DoD an incentive to objectively evaluate the benefits of its retail program (including intangible factors such as the impact on military cohesion and spirit). The department would have an incentive to limit the size and scope of that program to the point where the benefits provided by additional activities were balanced by the costs.

One way of implementing this alternative would be by requiring DoD to make payments to the Treasury in lieu of forgone taxes and requiring it to borrow capital from a federal credit account at the pretax, private rate of return. In addition, requiring exchanges to reimburse DoD for any in-kind support they receive would make the costs paid by DoD more visible. The department could use cash allowances to compensate active-duty personnel if those steps, as expected, led to higher prices in DoD stores.

How DoD Might Respond to Revised Incentives

In theory, the Congress could increase the defense budget to offset the expected tax and interest payments that DoD would make. That would allow the department to protect the morale and welfare of its personnel by providing goods and services at the same prices using the same mix of contract and in-house stores as it does today. Doing so would cost DoD an additional $1.6 billion a year--the value of the forgone taxes and return on capital. Faced with the full cost, however, DoD would most likely reassess the cost-effectiveness of using on-base stores with subsidized prices as a form of compensation.

The department would have a particularly great incentive to raise prices on merchandise sold in the United States, where the cost of forgone taxes and return on capital equals about 12 percent of sales receipts, or $1.4 billion a year (see Table 10). One of the disadvantages of subsidized prices as a form of compensation is that assessing the benefits is more difficult than assessing the costs. Nonetheless, under reasonable assumptions about the relationship between financial savings and patrons' benefits, DoD might find that the full cost of providing subsidized stores in the United States exceeded the benefits to both active-duty and retired personnel by about million annually.
 

Moreover, under the budgetary incentives provided by Alternative 4, DoD might find that it could save $1.5 billion a year by giving up subsidized prices and relying instead on million in annual cash allowances for active-duty personnel to attract and retain a high-quality force. (In Table 10, that $1.5 billion is the total cost of subsidies minus the benefits to active-duty personnel.) To the extent that promises of future benefits influence the retention decisions of active-duty service members, cash allowances would need to be greater than million. But to the extent that some of the benefits of the current system go to active-duty personnel in skills and grades that do not experience retention problems, the necessary cash allowances would be smaller.

If DoD responded to this change in incentives by eliminating subsidies in its U.S. stores (so receipts from patrons covered all of the costs of its retail activities, including taxes and the cost of capital), its retail role would change substantially. The focus of on-base activities would shift toward convenience stores and services such as fast food, dry cleaning, and barbershops, which target the needs of members living and working on-base and do not need subsidies to attract customers. On-base supermarkets and retail stores would no longer draw many off-base patrons. Sales of liquor and tobacco would decline sharply as prices rose to commercial levels.

Eliminating subsidies would ensure that the remaining activities operated as efficiently as possible. Forced to compete against private, off-base merchants on a level playing field, DoD's in-house facilities would be able to attract customers only if they could control their costs. In addition, contractors would no longer be at a disadvantage because of their tax treatment, and DoD might find that many of the activities remaining on-base could be provided more economically by contractors selected on a competitive basis than by DoD-run stores.

The Effects on Social and Budgetary Costs

Standard economic theory indicates that if DoD eliminated subsidies in its U.S. stores, society as a whole would save. Those savings are illustrated in Table 10 by the million difference between total subsidy costs and the benefits for all patrons of DoD's retail activities. The potential for savings to society arises because of differences in the efficiency of DoD and commercial retailers and the fact that subsidies encourage patrons to consume goods whose value to the patron is less than the cost of providing them.

Despite its social benefits, this change in budgetary incentives would not reduce costs to the federal or DoD budget much below current levels. As sales in DoD stores declined, so too would DoD's payments of interest and taxes to the Treasury. Much of the benefit from Alternative 4 would accrue to state and local governments and private investors.

In the extreme case that all sales from DoD's retail activities in the United States shifted to the private sector, DoD and the federal government might save million a year compared with the current system. That estimate takes into account the appropriated-fund costs and the NAF earnings of those activities, as well as the cost of providing million in annual cash allowances to active-duty personnel.⁽¹⁹⁾

The Effects on DoD's Activities Overseas

Paying a private-sector rate of return on the capital used by overseas commissaries and exchanges would cost DoD about million a year. DoD could choose to protect overseas personnel by not raising prices in its stores and instead using other funds to pay those costs.

Yet service members living overseas might benefit more if DoD eliminated all subsidies (including the current appropriated-fund subsidy) and set prices in commissaries and exchanges to cover the full cost of their operation. Under the current system, the price difference between DoD stores and local stores in many overseas locations is so great that service members may feel they have no choice but to shop on-base. That can be true even at bases in urban areas where local stores offer an attractive selection of goods. The overseas cost-of-living allowance reflects the prices in DoD and local stores and the extent to which members shop in each. If on-base stores charged higher, unsubsidized prices, service members would receive higher allowances and would be freer to use local stores.

Higher prices for goods in DoD stores overseas would also help to discourage black-market activities. In some locations, the potential gains from selling DoD goods on the black market pose a significant temptation for military personnel and their families. According to the commander of U.S. forces in Korea, "The persistence and pervasive nature of black-market activities here undermines the character of our community and our ability to teach the values we hold dear."⁽²⁰⁾

Substituting higher COLAs for subsidized prices overseas, however, would not necessarily reduce costs to U.S. society or the federal budget. Part of the benefit from cash allowances that were spent in local stores would accrue to the host nation. Nonetheless, a compensation system that is cost-effective in the broadest sense may be one that protects service members from the risk of facing poor living conditions on overseas tours. If so, the money used for higher overseas COLAs would be well spent.

One disadvantage of relying on subsidized commissaries and exchanges overseas is that it encourages DoD officials to focus on the welfare of the retail system rather than the welfare of military personnel. A DoD retail office that managed unsubsidized contractors instead of in-house enterprises might develop innovative approaches that would allow more overseas personnel to take advantage of the shopping opportunities offered by the local economy. Such approaches could include arranging for access to interpreters, special shopping hours, or vouchers (like those now provided for gasoline overseas) that would exempt local purchases from value-added and other business taxes. Such initiatives might become more valuable in the future as the integration of European markets and the growth of retail chains overseas enhanced the availability in local stores of familiar U.S. and international brand-name products.

Other Costs and Benefits of Subsidized Prices

Economic analysis suggests that in the long run, subsidized retail activities are not a cost-effective alternative to cash compensation for service members in the United States. That does not necessarily mean that DoD would eliminate all subsidies and rely entirely on cash compensation if it was faced with the full costs of those activities. Because some costs and benefits fall outside the conventional economic framework, DoD might conclude that paying some subsidies was worthwhile. In addition, cost-benefit analyses that focus on the long run overlook important one-time transition costs.

The Gift Effect. One benefit of subsidies that falls outside conventional economics might be called the "gift effect." It explains why private firms sometimes give their employees gifts (such as vacations or holiday hams) in addition to cash compensation. Even though the employee might be willing to trade the gift for a very small cash payment, the fact that the company chose to give him or her a gift conveys a message. In the military--where symbols of belonging are particularly important--subsidized in-kind goods and services that are available only to military personnel (health care, housing, child care, groceries, and retail goods) may be important not just for what they provide but for the message they send. Moreover, those benefits may send a message to all active-duty personnel, even those who do not choose to use them.

The extent to which service members view commissaries and exchanges as a symbol of belonging rather than simply as a low-cost and attractive shopping option is unclear. At least some members--particularly those at the beginning of their military careers--question the need for such stores at U.S. bases and express a preference for a system of cash allowances. In the words of one junior Army officer, "Personally, I would much rather have additional money added to my salary to cover purchasing groceries and food items on the local economy."⁽²¹⁾

Transition Effects. Analyses that focus on the long-term costs and benefits of cash and in-kind compensation fail to account for the disruption and one-time costs associated with moving from one system to another. Even though active-duty personnel as whole might be compensated for the change, a shift to cash allowances would produce individual winners and losers. In addition, it would be virtually impossible to compensate retirees, who are the prime beneficiaries of the current system.⁽²²⁾ Among those retirees are people who made decisions about jobs and housing based in part on access to commissaries and exchanges. Other losers would include employees of the current system (many of whom are family members of military personnel) and the private industry (vendors and military brokers and distributors) that supports DoD's retail system.

Concern within the Defense Department and the Congress about windfall losses might encourage DoD to continue providing some price subsidies even if it faced the full cost of doing so. One possible outcome would be incremental policies that gradually reduced but did not entirely eliminate price subsidies.⁽²³⁾

On-Base Shopping, Subsidized Prices, and the Nature of the U.S. Military. DoD leaders may also feel that on-base stores with subsidized prices shape the nature of the U.S. military in ways that economic cost-benefit analyses do not capture. That feeling could make DoD either more or less anxious to reduce its retail role. Subsidized on-base shopping (as well as child care, housing, and medical care) may be very valuable if military leaders want to preserve a unique military way of life distinct from that found in civilian communities. By the same token, subsidized on-base shopping may be undesirable if they want to encourage greater integration of the active-duty force with the U.S. population as a whole.

DoD's large retail role may have other drawbacks for the military as well. Operating a billion a year retail business with 96,000 employees could distract DoD leaders from their core mission; sales of low-cost tobacco and alcohol--two of the most profitable retail activities for DoD--could impair the health and readiness of service members; and access to goods at below-market prices could lead to fraud and scandal among store officials (as it has in the past) or undermine the character of military personnel by tempting them to engage in black-market activities.
 

The Future of DoD's Retail Role

Debate is growing within the Department of Defense about how to reduce the appropriated costs of commissaries and how to protect and increase the NAF earnings of exchanges. Options under discussion within DoD include pursuing the PBO initiative for commissaries, consolidating the exchange system, creating a single resale authority, and contracting out for commissary operations.

CBO's review of retail activities, however, suggests that the budgetary cost of operating on-base stores may not be the most important issue facing DoD's retail system. A more fruitful debate might focus on the nature and purpose of a system that increasingly serves retirees and reservists rather than active-duty personnel in overseas or isolated U.S. locations. That debate might start from the recognition that subsidized prices are not a cost-effective form of compensation once costs outside the DoD and federal budgets are considered. It might examine how DoD's immunity from state and local taxation makes the department reluctant to consider any reduction in its role. Taking into account the broad economic costs that the DoD retail system imposes on U.S. taxpayers, that debate might focus on whether DoD's current role in operating subsidized retail activities at military bases in the United States is justified based on their contribution to the military way of life and based on the disruption and costs that a change would entail.

1. Memorandum from the Assistant Secretary of Defense for Force Management Policy to the Secretaries of the military departments and the Chairman of the Joint Chiefs of Staff, January 8, 1997.

2. The study group was chaired by Lieutenant General Donald W. Jones, Deputy Assistant Secretary of Defense for Military Manpower and Personnel Policy. See Department of Defense, Study of Military Exchanges (September 7, 1990), p. 1-5. The annual savings of million reflects the group's estimate adjusted for inflation.

3. Office of the Secretary of Defense, Exchange Integration Study: Summary of Gains and Costs (prepared by SRA/Gimbal, December 10, 1996). The million excludes estimated savings from changes in business practices (rather than consolidation), but it does include million in assumed savings from increased purchasing leverage due to consolidation.

4. The ,000 figure is based on average hourly earnings of .55 (including fringe benefits) and an assumed 40-hour work week. The average hourly earnings reflect the level of hourly earnings (.18 before fringe benefits) reported for food store employees by the Bureau of Labor Statistics and the ratio of benefits to salary costs (29 percent) reported by the Food Marketing Institute.

5. DeCA's total labor costs in 1995 were approximately million. CBO's estimate of the potential savings from lower wages excludes supervisors' salaries and the wages paid to foreign workers at overseas commissaries. It does not account for transition costs.

6. President's Commission on Privatization, Privatization: Toward More Effective Government (March 1988), p. 145.

7. To avoid that, DoD would need to set the prices that it charges DeCA for those services so as to accurately reflect the additional costs of providing the services.

8. Those provisions are a modification of the so-called "mattress decision," which prohibits an appropriated-fund agency from avoiding competitive procurement rules by using a nonappropriated-fund instrumentality as its purchasing agent.

9. That estimate is relatively insensitive to different assumptions about the relationship between DoD prices and sales. If sales of nonfood products fell by 10 percent (a 0.5 percent decline in sales for each 1 percent increase in price), savings would still be million because reduced sales of goods priced at a 5 percent markup actually lead to savings. The estimate is based on a CBO analysis of the relationship between store sales in 1995 and store costs. That analysis indicates that a 10 percent decline in sales is associated with an 8 percent decline in operating costs (see Appendix C).

10. These figures do not include the cost of capital.

11. The new BAS might be designed to cover the total cost of food consumed by the service member and, for members with dependents, to provide a subsidy equal to some fixed percentage of the food costs incurred by the typical family. That approach, however, would tend to overcompensate married personnel with small families and under-compensate those with large families.

12. This requirement might prove unnecessary. A resale authority that sold commissary items at subsidized prices would be likely to require appropriations rather than generate earnings.

13. Of course, the exchanges could continue to spend million a year to ship beverages overseas if they felt the benefits to service members justified it.

14. That risk might be overcome by an overseas subsidy based on the equation:

overseas subsidy = B (overseas sales - 1995 overseas sales)

where B is the subsidy provided for each additional dollar of overseas sales and 1995 is used as a base year. B might be set so that it just covered the expected cost of transporting an additional dollar of goods overseas. That formula would ensure that increases in overseas sales were rewarded and declines penalized without requiring a large level of appropriated support for the exchanges and without distorting managers' use of resources. The expected value of the subsidy payments would be close to zero.

15. Defense Science Board, Achieving an Innovative Support Structure for 21st Century Military Superiority (November 1996), p. II-104.

16. See Alan J. Marcus, Analysis of the Navy's Commercial Activities Program, CRM 92-226.10 (Alexandria, Va.: Center for Naval Analyses, July 1993), p. 26.

17. Standard & Poor's, Retailing Current Analysis, Standard & Poor's Industry Surveys, vol. 163, no. 41, section 1 (October 12, 1995), p. R64.

18. That amount includes about million in forgone taxes and return on capital for U.S. commissaries (shown in Table 3) and about million for U.S. exchanges (shown in Table 7). Capital costs for contractors would be less than those figures indicate to the extent that DoD provided buildings without charge. Contractors would have to provide inventory and equipment, however. In addition, DeCA benefits from legislation permitting it to treat baggers as independent contractors. Unless that right was extended to contractor-run commissaries, the need to pay baggers' salaries could add another million a year to contractors' costs.

19. Based on 1995 data, the annual cost of the current retail system to DoD is about million. That is equal to DoD's appropriated-fund support for U.S. commissaries ( million), plus its appropriated-fund support for U.S. exchanges ( million), minus the NAF earnings of U.S. exchanges ( million) that DoD could use for costs that might otherwise be paid with appropriated funds, plus the NAF earnings of concession activities that would continue to operate ( million). That estimate does not take into account the impact of reduced capital requirements on Treasury borrowing costs. Savings would be larger if some in-house stores were replaced with fee-paying concessions.

20. Colonel John D. Kennedy, quoted in Eric Schmitt, "Army Cuts Its Beer Ration, and Brewers Are Furious," New York Times, July 5, 1997, p. 1. Sales of beer by exchanges in South Korea fell by half when the Army cut the number of cases that a soldier could buy each month from 30 to eight.

21. Letter from Kimberly Phelan, 1st Lt., U.S. Army, quoted in Cathy Riddle, "Patrons Value Their Shopping Benefit," Military Market (January 1994), pp. 10, 18, 21.

22. Retirees vary greatly in the distance they must travel to reach DoD stores and in their use of those stores. A system of cash allowances that adequately compensated retirees who use the stores would greatly overcompensate those who do not and thus prove prohibitively expensive.

23. Reductions in the largest price subsidies--including those on commissary items--have the potential to significantly reduce social costs because the inefficiency caused by a subsidy is proportional to the subsidy squared.