Regional President Speech

• !. , ·" Statement of Frank E. }Iorris President, Federal Reserve Bank of Boston Before the Senate Committee on Banking, Housing and Urban Affairs, May 18, 1972 I am happy to have an _opportunity to tc~tify on behalf of S. 3215 wh i ch embodies, in my j ud gmen t the best approach to j. broadening the market for the securities of st a t e and Ioca l governments. Such a broadening of the market is essential if the capital needs of state and .local g o ve rnrae n t s a Te to be adequately fin~~ced in the decade ahead. I should make it clear from the outset that I am testifying as a long-time student of the municipal bond market, not as a representative of the Federal Reserve System. As you know, the Federal Reserve has not yet taken a position on this bill. Over the course of the past-seventeen years I have had an opportunity ·to study the municipal bond market from a number of vantage points. As Research Director for the Invest rre n t B an k e r s Ass o c i at ion, I ob serve cl the market from. the stand point of the bond underwriter. As Assistant to the Secretary of the Treasury for Debt Nan age mc n t (1961-63) > I had an opportunity to view the ma rk e t from the st an dp o i.rrt 0£ the U. S. Treasury. Subsequently, I s aw the market from the standpoint of the investor as a Vice President of Loomis, Sayles and Company, an .i nve s t mc n t counselling firm which buys substantial amotu1ts of muriicipal bonds for its clients. In my present capacity, I have exp r e s s e d my coric e rn that the nun i c i pa I b on d market, as it is presently constituted, has too narrow a base to meet t.h e rapidly g r ov i n g financial needs of state an d Loe a I governments in an adequate m an n e r , Moreover, because of its extreme dependence on the comra~rcial banks, the existing t a x+e xe mp t market is extremely s e n s Lt i ve to changes in ~O!letarr policy. All of us in the Federal Reserve are concerned about t n e un c ve n .i mp a c t of a tight money policy on the various sectors r ._ . ; .. : ... : . ~ - 1 ~ r • ic - \ ' (" - ", '' ,- -- . ' ~ -". ~ .,"- n "-./' ,.- ·" ,, ,.' , • r J p ..~ , . • .. V A ' r -' \ " r: - : + l,,,...J h l r \... \ , J 'r t :" l ll , " J '\ J C"~ + ~ Y } " -- l ' " J . .. V " J .,. ~ .., t.. . . . . ; L y ll , . r '- ' • \ J 1'' L "1+ .' '\ V : "- -L - '- + L - ... .; l . !! ,, I_ , - . , V "" . . . . .l c . C ~ L .. \ . . . . - . L .:r ~ ~l l -- l ~. \ f . . . .. . . r.on e y p o Li c y are h ou sin g an d s t a t e an d local r:ovcrnmcnts. We wi Ll n e ve r elir.~inatc this problem co mp Ic t c Ly un t i l '"'h·e Le a rn to control Fc d e r a l Co ve r n me n t fi seal pol icy no re resp on~-...; 11 Ly t.h an j n the past c1.nd until 1-.:c adopt r.c a s u rc s wh i c h wi Ll n i t i o a t c La r ce sw i n c s in ~ '-" \.> ~, . Page tho business capital investment. Nonetheless, we can do a great deal to improve the situation by strengthening the markets for the securi t i.e s of the weaker claimants on the flows of capital· funds. We have undertaken to strengthen the mortgage market and our efforts have met_ with some considerable success. While housing did not escape.the money squeeze of 1969-70, the co~traction in housing starts was, in my judgment, much less than it would have been had He been operating 1.·:i th the same sort of nortgage market that we had in 1966. Thus far, however, we h ave done nothing to improve the· structure of the municipal b on d market. S.321S would create a dual market for municipal bonds. The tax-exempt market would continue to function, but the volume flowing through it wou l d be reduced and yields on tax-exempt bonds would be lower. The breadth of the impact of the dual narket will pe directly related to the level of the interest subsidy paid. on tax ab le bonds. 11[i th a one-third int.eres t subsidy in a tight money year. such as 19 69 tax ab le bonds would amount > to 20 to 25% of the total volurae of new issues,·with the volume of taxable bonds falling off to about 10% of the total in an easier mon e y year such- as 1968. The principal contribution of the taxable raunicipal market in relatively easy money ye~rs, such as 1968 or 1971, would be to act as a safety valve for periods of congestion in the tax-exempt market~ The s tarting point in any as s es s men t of the cos ts· and benefits of S .. 3215 is the r-e c o gn i t i on that there would then be two Federal subsidies in effect on municipal bonds: the subsidy given indirectly through tax exemption (since tax-exempt bonds under a 33% subsidy would still remain the ~ost widely used financing vehicle) an d the s ub s i dy gi v e n di r e c t Ly on taxable municipal bonds. One of t~e most constructi-re results of S.3215 would be to improve the efficiency of the subsidy given through tax exemption by automatically preventing an overloading of the tax-exempt market. There is a lot of room for improvement. The Treasury es~im2.ted t.h a t in fiscal 1968 the cost of t.?LX exemption to the T'r-e a s u rv w a s $1.8 billion, wh i I.e the interest savings to state and Lc c a I g~n;rnments amounted to $1.3 billion - - leaving a gap of ~SO O rri 11 ion wh i c h accrue cl to the benefit o-f high-bracket i :-i c. i -: id u al s , co mm e r c i a 1 b an ks an d casualty i n s u ran c e comp an i e s . Ha:r-Yc.-Y Galper of the Urban Institute estimates that in fiscal 1971 the cost of tax exemption to the T're a u ry had risen to ~ 3. 3 h-:i 11 ion. the interest s n,i v i n z s of s t a t e an d local pove1nments gap to $2.5 bjllion - - leaving of $800 rrt Ll i cn accr~ing to the be~efit of private investors. In a s s e s s in g the costs, if an y , of S.32i"S, the Congress s :i C)U l cl not for g c t that the T re: 2. s u r y i s al re .:-u l y s uh s i di z i. n g i n a :- . as s 1 v ,:; a!'.. c1 g 1· o s s 1 y i n c f f ·i. c i e n t m an n e r th e L1 c h t ·i s s u e s o f s tat e and local govei-nments.. It is, to my kno\-rlcdgc, the only subsidy given by the Federal Government in wh i.ch the cost to the govern;-:-cent is obviously much greater than the benefits received by the inten~e<l beneficiaries. If S.3215 were adopted, the relative size of this gap (which represents a major source of ineauity in our income tax structure) ~ould gradually be reduced, al though it ·will never be eliminated w i th a on e= t h i rd subsidy level. The process of analyzing the costs and benefits of S. 3215 is exceedingly complex because the rcsul ts w i 11 vary from year to year depending on how the new issue r o Lurne is split ~et¼een the tax-exempt and.taxabla markets, and this split will d e p e nd o:;.1 the financial conditions prevailing in the economy at the t i r.e , given the te rrns of the two sub si dies. An econometric capital markets model is needed if we are to attempt to quantify the costs and benefits of this bill. Until recently, only one model had been developed which was capable of handling this problem - - the raodel developed at the Urban Institute. by Galper and Petersen. For two years work has bee~ proceeding at the Federal Reserve Bank of Boston under the direction of Peter Fortune toward generating a capital markets nodel capable of dealing with a broad array of financial problems. This model is much more complex· than the Galper-Petersen model (40 equations v e r sus 4) and, \•!e believe, technically superior. I will not attempt to describe the model in "QY statement, but I am sub~itting a supplementary statenent describing the model for the use of .the Co mm i ttee. The tables whi c h f o l l ow compare the results of the two nodels for the period 1968-70. Table I e s Li m a t e s how the market ·.·:ould have been divided between tax-exempt and taxable bonds du r i n g the 19 6 8 - 7 0 p e r i o cl with sub s i c1 y r o. t e s of 3 3 % and 4 0 % • · The Boston F~d model indicates that with a 33% subsidy taxable bonds w ou l d have accounted for 9°6 of the market in 1968, rising to ab o u. t 2 196 in the ti g ht money ye a r of 19 6 9 an cl fa 11 in g to 14 % . in 1970. If a 40% subsidy rate were to be adopted, which I would personally favor, a much greater broaderring of the municipal bond ma r k e t wou l d result. Our mo de I seg:~est.- that t axab Le bonds under a ,io 9 a subsidy would have constituted 'L 1 • out 40% of the market. i n 19 6 9 and b ct Hee n 2 0 % an cl 2 5 % o f the mark e t. in 19 6 8 and 19 7 0 • Table II presents our a t t e np t s to qu an t i f y the costs· a n d b e r.c I i, ts un dc r both a 33t and a 40% s ub si cly. The most c1. i ff i c •- ~ l t p o i n t i n th c an a 1 y s i s i s t 1 L., ;:i. s ~ u Fl p t i on ,.,,, i th r c s p cc t to the a vc r a ge tax b r a ck c t of the r nv c s t o r s ,-:ho wo u l d be sh i Et e d out of t .:i.. · - ex c mp t b on cl s i n to t 't x ab 1 e s e c u r i. t i c s . I n o u r mode 1 w e h av e operated under the same a s s ump t i o n a- Galper-Petersen. We ha .. ·c a s s uric d a perfect market in w h i.c h the m a r g i n a I buyer of ~unic~1r,··al bonds 'i s at c:1 "·bTeaL-c\·cnrr position rc]J.tivc to corporate. })o:1ds a n d the nar g i n a I tax rate to be ap p Li o d i s at the mi.dro:i.nt of t h c tvo 1 'brcak-cvcn11 rates, before an d after s ub s i d y . Th.is a s s um.i t i o n has ~t theoretical n i c ;. .. t,: .:-ihout j _ au d i t is we Tl adapted ':.o th~ nrc d s of the co:nputcr, but '1 ar: not r o n v i n c c d that it is TABLE I SHARE OF TAXABLE STATE-LOCAL BONDS It1 TOTAL GROSS ISSUES OF STATE-LOCAL BONDS DURING 1968-1970 IF TAXABLE BOND OPTION HAD BEEi; ADOPTED IN 1968 .• ,:;? • Market Share with "-· ~•:arket Share with 33% 'Sub s i.dy Rate 40% S_ubsidy Rate FRB-BOS · ·Galp·e·r-Pe·te·rsen- FRB-BOS Galper-Petersen Period 25.5% 20.2% 1968 8.8% 0 1969 20.5% 23.5% 39. 7%, 55.2% 1970 ' "14.3% 11. 7% 22.4% 33.3% . . . . . ... . , • ~ 1968-70 13.9% 10.5% 2 7. 9 % 34.3% . . . ' .. Source: Model Simulations in Tables I and II of paper "The Benefits and Costs of Allowing State-Local Governments to Issue Taxable Bonds with a Direct Subsidy: Application of the FRB-BOS Capital Market Mode 1." TABLE II BENEFITS k~D COSTS OF TAXABLE BOND OPTION OVER THREE YEAR PERIOD 1) 33% 40% Subsidy Rate Nethod of Estimation FRB-BOS Galper-Petersen FRB,BOS Galper- Peters en · Direct Subsidy Cost 255 207 681 89 S Higher Interest Cost 2) 18 27 50 85 Total Cost to Treasury 273 234 731 980 . Additional Tax Revenues 244 134 629 570 .. . . . - Net Cost to Treasury 29 100 102 . 416' Low e r S&L Interest Costs 42 40 204 199 Increased S&L Borrowing 644 1,203 , 1,215 3,423 1) Source: Model Simulations in Tables I and II of paper "The Benefits and Costs of Allowing State-Local Governments to Issue Taxable Bcn ds with a Di r c c t Subsidy: App1 ica ti on of the Fl B-BOS Capital Market !'• f O d .__, 1 . II - 2) Higher interest cost to the Treasury on its own'borrowings due to the increased volume of taxable bonds. r·ctgt:: 1.UUJ. necessarily descriptive oE the real world. I suspect that there a re ma j or dis cont in u i ties in the market· f o r mun i c i pa 1 b on <ls an cl that, therefore, the cost to the Treasury of t~c subsidy program may well be ove rs t at.e d in our model. For this reason, I believe that the cost figures generated by the model should be viewed as the maximum cos ts rather than median or most prob ab le cos ts. I~ any event, our model generates very small net cost figures to the Treasury, substantially lower than the estimates produced by the Galper-Petersen model. Our "maximum" cost estimates for the three-year period 1968-70 amount to $29 million under a 33% s ub s i dy and $102 mi.Ll i.on under a_ 40% subsidy. Against these "maxi mum" costs the model indicates an array of benefits which clearly indicate that an exceedingly high ratio of benefits to costs.would be produced ~y this bill: 1. Lower interest costs to state and local governments which vastly exceed the "maximum" costs to the Treasury. 2. -The ability of state and local governments to sell their bonds in two markets w i I I permit state and local governments to cope much more effect~vely both wit~ periods of tight money and with periods of temporary congestion in tne 'tax-exempt-market ·. 3. By preventing an overloading of the tax-exempt market, the efficiency of the $3.3 billion subsidy given through tax exemption would be .i mp r ove d substantially over t i me . . 4. As a consequence of the imp roved efficiency of the tax-exempt market, the element of inequity in our tax structure stemming from tax· exemption would be substantially reduced over time. • I can appreciate the concern ·of the Congress in contem- plating the f i-naric i n g of. a new program through a pe rman en t , indefini.te appropriation in the absence of hard data on the costs o f the pro gram. The fact is, however, · that there are. no hard data with regard to the tax position of the investors who would be forced out of the tax-exempt market by this bill. We cannot say with any certainty that the Treasury will not break even or even s h ow a net gain from the .i mp Le me n t a t i ori of this bill. The most important product of the Boston Fed model, in my judgment, is the finding that, even under the most disadvantageous assump tion with regard to the average marginal tax rate of the displaced investors, the cost of the pro gram to the Treasury w ou Ld be very small and the benefits to state and local governments very large .. Even under this Horst possible assumption, we should look upon the bi 11 as providing a un Lq u e form of r c vc nue sharing in wh i ch state and local governments received s e vc r a l dollars bencfi t for every dollar spent by the Fe de r a L Cove rnrae nt . · This is an important piece of legislation. There is a critical n c c d to broaden the market for s ta r c and local govern- rn c n t s cc u r i ti es . 1' I}' p e rs on a 1. p re f e re n c e w o u 1 l1 b c to s to. rt out \d th a tl O i sub s i cl y 1 c v c 1 ,v h j ch h. i 11 gen c r a t c a mo r c cont i nu o us Page five • dual market in state and local go~rnment securities, in contrast to the spasmodic dual market which is likely to be produced by a 33% subsidy level. ✓ I believe there is a need for the broader market which a 40% subsi~y level would produce. Nonetheless, this bill is a great step in the right direction. I suspect that once the C~ngress and state and local governme~t officials gain a full appreciation of the benefits of this bill, there will be a demand for further steps. . ., •• ·- • • ,

Frank E. Morris (1972, May 17). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19720518_frank_e_morris

@misc{wtfs_regional_speeche_19720518_frank_e_morris,
  author = {Frank E. Morris},
  title = {Regional President Speech},
  year = {1972},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19720518_frank_e_morris},
  note = {Retrieved via When the Fed Speaks corpus}
}