Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Cost-Plus Contracts Inflate Government Spending by Billions
Transcript
- Lucas: So last week the Government Accountability Office put out its annual report on major defense programs, and the number that jumped out at me is two trillion dollars. That's the total cost overrun across the 100 or so programs they track. Luna: Two trillion? That's more than the GDP of most countries. How does that happen? Lucas: A big chunk comes down to one thing: the type of contract the government uses. It's called a cost-plus contract, and it pays contractors for their costs plus a guaranteed profit margin. Luna: So the more they spend, the more they make? That sounds like an open door for waste. Lucas: Exactly the perverse incentive. If a contractor comes in under budget, they lose profit. So there's no reason to be efficient. Take the F-35 program — the most expensive weapon system in history, lifetime cost over one point seven trillion dollars. It's been plagued by delays and overruns, and a major reason is that early development used cost-plus contracts. Luna: Did they ever switch to fixed-price later in the program? Lucas: Partially, but the damage was done. And this isn't just defense. The Department of Energy, NASA, even the Department of Transportation use cost-plus for big projects. The GAO found that programs using cost-plus had cost growth of 31 percent on average, while fixed-price contracts had growth of just 4 percent. Luna: Why does the government keep using them if they perform so much worse? Lucas: Two reasons. One, when the scope of work is uncertain — like developing a new technology — it's hard to write a fixed-price contract. Two, cost-plus is politically easier. It guarantees a profit for big contractors who have lobbyists. A fixed-price contract might scare them off. Luna: So a mix of technical difficulty and political capture. But with two trillion at stake, you'd think Congress would push harder for reform. Lucas: There have been pushes, but they keep getting watered down. A classic example is the F-35's software development. Under cost-plus, Lockheed Martin didn't consolidate the software until very late because they could charge more for fixing integration issues later. A fixed-price contract would have forced them to get it right earlier. Luna: And that's just one program. Multiply that by a hundred and you get two trillion in overruns. Lucas: Right. And when we talk about fiscal policy and the national debt, we focus on entitlements and taxes, but procurement is a huge leak. The GAO says better contract management could save tens of billions annually. Luna: There must be some successes though. Have any major programs turned around using fixed-price? Lucas: Yes, the Department of Defense used fixed-price contracts for the GPS III satellite development and saved over a billion dollars compared to earlier models. So it's not that it can't be done. Luna: So what's stopping more programs from going fixed-price? Lucas: The biggest hurdle is that the people writing the contracts — acquisition officers — are incentivized to avoid risk. A cost-plus contract is less likely to fail spectacularly, even if it costs more. A fixed-price contract might lead to a contractor walking away, which looks bad for the officer. Luna: So the government's own risk-aversion becomes a source of waste. That's a textbook principal-agent problem. Lucas: If that kind of analysis is useful to you — the reason we can keep digging into these arcane but important subjects is that the show stays ad-free. And that's possible because listeners who find value in it sometimes chip in. If today made something click for you, you can support by heading to buy me a coffee dot com slash fexingo. It's really that simple, and it helps us do episodes like this. Luna: Yeah, no pressure. It's just a way to say this matters to you. Lucas: Exactly. So now, looking ahead: there's a bill in Congress right now, the Procurement Reform Act of 2026, that would require more fixed-price contracts for major programs. But the lobbying against it is intense. Luna: I've seen that — some of the same companies that benefit from cost-plus are spending heavily on ads saying fixed-price contracts will lead to more failures. Lucas: And that's the debate: do you accept more risk on individual projects to save money overall? The evidence from GPS III suggests yes, but it takes political will. Luna: It's a trade-off voters rarely hear about, but it affects the deficit more than most people realize. Lucas: And that's really the core of fiscal policy — understanding where the money goes and why. Thanks for listening to The Fiscal Policy Podcast with Fexingo.