would pay a subsidy directly to the issuing units to offset a portion of the interest cost. However, repeal of the tax exemption has proved to be so politically unpopular that it seems out of the question. The Urban Development Bank is a compromise proposal, which would accomplish some of the objectives that proponents of repeal have in mind and would in some ways be more efficient than a system which provides for direct sale of taxable securities by State and local governments.

The Bank would be able to borrow more economically than would the state and local governments themselves if their issues were taxable. There are two reasons for this: (1) the Bank's securities would be fully guaranteed by the Federal Government and would therefore be free of default risk; and (2) the Bank's borrowings would tap a wider market and would be offered on a larger scale and in a more unified way than would the direct borrowings by State and local governments, many of which would necessarily take place in narrow markets and be adversely affected by the small size, large number, and varying acceptability of the issues. The operations of the Bank would take pressure away from the tax-exempt market, thereby making it unnecessary to press tax-exempt securities on some investors in lower tax brackets and also making it less dependent on commercial banks. In this way, the Bank would benefit those government units which continued to use the tax-exempt market by enabling them to borrow at lower costs. It would also lessen the inequity of the tax exemption by reducing the extent to which the benefits go to wealthy taxpayers rather than to State and local governments. In this way it would partially achieve the objectives that outright repeal of the tax exemption would be designed to accomplish.

3. The statute says very little about the interest rate policy to be followed by the Bank, wisely leaving the matter to the discretion of the Bank's management. However, it is difficult to imagine a Federal Government agency charging different interest rates to different State and local government borrowers. Moreover, the safety record of tax-exempt securities in recent years scarcely seems to justify such a discriminatory practice-although, of course, the Bank might refuse to lend to a government unit whose financial practices were judged unsound. Assuming, as seems reasonable, that the Bank would lend at the same interest rates to all borrowers, it should prove to be especially attractive and valuable to smaller units whose tax-exempt securities would receive low ratings or be unrated and who would therefore be charged especially high rates in the tax-exempt market. 4. By reducing the reliance of State and local government on commercial banks, whose lending practices are especially sensitive to changes in general credit conditions, the establishment of an Urban Development Bank should reduce-though not entirely eliminate-sensitivity of State and local government borrowing and capital spending to monetary policy.

5. The Federal subsidy paid to the Bank would not involve a net cost to the Federal budget as long as it did not exceed the saving to the Federal Government resulting from the substitution of taxable securities issued by the Bank for taxexempt securities that would otherwise be issued by State and local governments. To illustrate the relationships, suppose the interest rate on new issues of taxexempt securities is 5 percent, the rate on guaranteed taxable bonds issued by the Bank is 6 percent, and the marginal Federal income tax rate of investors in the Bank's bonds is 40 percent. If a municipality borrowed $1 million in the taxexempt market, it would pay 5 percent, and the Federal budget would not be affected. On the other hand, suppose the municipality borrowed $1 million from the Bank and the Bank sold $1 million of its own bonds to finance the loan. The Bank would borrow at 6 percent; and if it charged an interest rate one-third below its borrowing rate, as the proposed statute would permit it to do, the interest rate paid by the municipality would be 4 percent. The annual subsidy paid by the Federal Government to the Bank to cover the difference between its borrowing and lending rates would be $20,000 (.02 × $1 million), which would appear as an expenditure in the Federal budget. On the other hand, the extra tax on the Bank's bonds would be $24,000 (.40 × .06 × $1 million), and this would appear as a receipt in the budget. Thus, in this case, utilization of the Bank would actually reduce the Federal deficit. What the budgetary outcome would turn out to be in reality is quite difficult to predict, since it would depend on what came to be the prevailing relationship between interest rates on tax-exempt securities and on the taxable bonds of the bank, on the rate of subsidy paid to borrowers from the Bank, and on the marginal tax rates of holders of the Bank's bonds. At the very least, however, it is clear that the extra tax receipts derived from the substitution of taxable for tax-exempt bonds would offset a large part of the cost of the sub

sidy paid to the Bank. Indeed, the fact that a large part of the subsidy from tax exemption goes to wealthy taxpayers clearly indicates that the same subisdy that is now being given to State and local governments through the tax exemption could be provided through the Bank at less cost to the Treasury.

III.

I would now like to discuss rather briefly the way in which the Bank might actually operate under varying credit market conditions.

It should be understood that the Bank's lending rates would be tied to its borrowing rates, the difference between the two being the subsidy paid from the Federal Treasury. Thus, the Bank's lending rates-which would vary according to the maturities of the securities it acquired-would rise and fall with the general level of market interest rates.

To illustrate relationships on the basis of the recent interest rate situation, the Bank might be able to borrow for 20 years at an interest rate of 7.8 percent, the market yield on Government agency securities of 20 years' maturity.14 If it received a subsidy equal to one third of its interest cost, it could lend on 20-year securities at about 5.2 percent. This would be substantially below the current yield on 20-year prime quality municipal bonds and, of course, still further below the yields on lower quality municipals. The actual operations of the Bank would be more complex than this illustration, because the Bank would be both borrowing and lending in a variety of maturities. But the point it brings out would surely hold true nevertheless: if the Bank's lending rates were, on the average, two-thirds of its borrowing rates, it should, to begin with, be able to lend at rates more favorable than those available to municipal borrowers in the tax exempt market.

Thus, if the Bank were to go into operation at the present time (and the situation would surely be essentially the same at almost any time), most State and local government borrowers would probably find its interest rates more attractive than those available in the market for tax-exempt bonds. However, there would be market forces at work which would tend to correct this situation. As increased demands on the Bank forced it to borrow more, its borrowing costs would rise, thereby pulling up its lending rates; at the same time, the reduction in demands in the tax-exempt market would reduce borrowing costs there. There would be some level of lending by the Bank at which these forces would, in principle, produce equilibrium with a Bank subsidy rate of one-third. If net borrowing by State and local governments was at the rate of around $12 billion per year (measured by the net change in outstanding State and local government securities) which prevailed in 1970, the question is whether the equilibrium would involve more than the $5 billion per year of lending by the Bank that is provided for in the statute.

If $5 billion per year of lending by the Bank was not sufficient to produce equilibrium with a subsidy equal to one-third of the Bank's borrowing rate, it could do one of two things:

1. It could continue to lend at a rate subsidized to the extent of one-third, rationing credit in some other way to stay within its $5 billion lending quota;

or

2. It could reduce the subsidy below one third, thereby raising its lending rates sufficiently to produce an equilibrium within its lending quota.

I believe it would be distinctly preferable for the Bank to follow the second of these procedures, (which the proposed statute would permit), thereby using interest rates as a means of rationing credit. This method would assure that those borrowers who, due to low credit ratings or the absence of such ratings, would have to pay high interest rates in the tax-exempt market would be accommodated by the Bank.

As credit conditions changed, demand for accommodation from the Bank would change to some extent. The main reason for this is the residual role that commercial banks play in the municipal securities market. As explained earlier, when credit tightens, banks focus on meeting the loan demands of their business customers, retreating from the tax-exempt bond market. It is primarily because of such behavior by banks that municipal borrowing costs rise more than other interest rates in periods of tight credit. This is largely the basis for the argument that restrictive monetary policy "discriminates" against State and local governments. If the Urban Development Bank could keep its subsidy rate constant during 14 This estimate is taken from a yield curve for Government agency issues compiled by Salomon Brothers for July 23, 1971.

periods of monetary restriction, it would counteract this tencency by acquiring a larger share of new offerings of State and local government bonds during such periods. State and local borrowing costs would, of course, still rise during such periods (as they should), because the Bank's borrowing costs would rise. But the past tendency for these rates to rise relative to other interest rates, thereby imposing a disproportionate burden on State and local governments, would be counteracted at least in part.

IV.

The one significant difference between the present Urban Development Bank proposal and the one contained in the Johnson Administration task force report referred to earlier is related mainly to the issue of keeping the Bank's lending operations outside the Federal budget. The task force report proposed establishment of the Bank as a quasi-private corporation chartered by the Federal Government. The Bank's securities would either have been guaranteed by the Federal Government or an indirect guarantee would have been provided by giving the Bank power to borrow from the Treasury up to some limited amount. In addition, the Bank would have had equity capital, to be obtained by voluntary subscription and by requiring each borrower to purchase its stock to the extent of 1 percent or 2 percent of the amount of the loan. The establishment of the Bank as a quasiprivate corporation with an element of private equity capital would have followed essentially the FNMA model and would have assured that its lending operations would be outside the Federal budget.

Although some proponents of an urban or community development bank would contend that there is some positive benefit in having State and local governments possess equity in the Bank, I would attach little or no importance to this argument. The truth is that the task force recommendation that the Bank be quasi-private with an element of equity in its capital structure was primarily a subterfuge for keeping it out of the budget. This being the case, I prefer the procedure followed in the proposed statute, because it is more straightforward, simplifies the structure of the Bank, and makes its entirely public purpose clearer.

This provision does, however, bring into even sharper focus the issue of the appropriateness of the inclusion of net lending in the budget. There are several aspects to this issue.

1. Many economists have consistently been opposed to including net lending as an expenditure in the budget on the grounds that inclusion of net lending along with purchases of goods and services and transfer payments is improper. When the government borrows in order to finance loan programs, it merely performs an intermediary function very similar to that of a private financial institution, and its lending adds equally to the assets and liabilities of the private sector. Thus, in general, government lending programs are more akin to debt management or monetary policy than to fiscal (taxing and spending) activities which properly belong in the budget. Of course, the situation varies from one program to anotherfor example, nonrecourse loans to farmers by the Commodity Credit Corporation are closely akin to government purchases (and are in fact treated as purchases in the government sector of the national income accounts-N.I.A. budget-which, in general, excludes lending activity). Nevertheless, it is generally correct to say that lending should not be lumped in with spending.

2. Some Government lending activities are outside the budget, because they are carried out by institutions which are ostensibly "private" even though they have a public purpose and their policies are established by government officials. The most striking example of this is FNMA, whose lending activities were removed from the budget when it "went private" in 1968. The only essential difference between FNMA's activities now and before its removal from the budget is that they are now carried out on a much larger scale, precisely because they are no longer subject to a Federal budget constraint! Thus, the concept of "net lending" as a component in the Federal budget, which rested on a shaky analytical foundation to begin with, is rendered virutally meaningless by the existence outside the budget of ostensibly "private" agencies whose activities have an economic purpose essentially identical with activities included within the budget.

3. The budget "net lending" concept is now being rendered even more meaningless (if that is possible) by the Congressional practice of classifying lending_activities outside the budget, as was recently done in the case of the Export-Import Bank and as is proposed for the Urban Development Bank by the legislation now being considered.

No action by the Congress is called for in connection with this matter. However, I believe it would be desirable for the Bureau of Management and the Budget to take steps to remove net lending from the unified budget-and beyond that to bring the other categories of the unified budget still more closely into line with those employed in the national income accounts. If these steps were taken, we would truly have one Federal budget which would be useful for both fiscal and program analysis. In presenting that budget, it would be desirable to include a memorandum item showing Federal lending activities whether carried out by the Government itself or by ostensibly "private" agencies serving a public policy purpose. Government lending activities should be subjected to the same (and continued) scrutiny as spending. But this does not require inclusion in the budget. The purpose is accomplished by making subsidy elements explicit and requiring appropriation.

I believe an Urban Development Bank, properly established and operated, would contribute to several important public policy objectives. It would make capital available to State and local government units on somewhat more favorable terms, benefiting especially smaller units whose position is weak in the taxexempt market. By taking pressure off the tax-exempt market, it should enable units which continue to use that market to obtain better credit terms than would otherwise be the case and also lessen to some extent the tendency of that market to benefit wealthy investors rather than State and local governments. It should moderate the present tendency of restrictive monetary policies to "discriminate" againts State and local governments, while still leaving those governments subject to the legitimate discipline of such policies. It might also contribute to improved planning and project evaluation by State and local governments. Having said all of that, however, I want to emphasize that the Bank, if established, will by no means assure that an ample supply of capital will be available on reasonable terms to meet State and local government needs. The operations of the Bank will be to no avail in this respect unless we adopt a combination of fiscal and monetary policies which enables us to keep the national economy operating at full employment with a sufficient supply of saving, private and public (through the Federal budget) to satisfy the capital needs of all key sectors, including the State and local government sector, at reasonable interest rates.

Mr. BARRETT. Thank you, Dr. Smith.

Mr. Brady, we are certainly happy to have you here this morning, coming all the way from Toronto. And we are waiting very eagerly to get your information and advice.

STATEMENT OF P. E. H. BRADY, TORONTO, CANADA, FORMER DEPUTY MANAGING DIRECTOR OF THE PROVINCE OF ONTARIO HOUSING CORP., ON STATE AND METROPOLITAN DEVELOPMENT AGENCIES AND HOUSING BLOCK GRANTS

Mr. BRADY. Mr. Chairman, ladies and gentlemen, first of all, I am very pleased to be here. We were privileged to have had a visit from your group recently. I told Metro Chairman Campbell that I was coming to Washington. He asked to convey his best wishes to you. And we hope to have a return visit from your group.

I am also pleased to be at this table with Philip Brownstein and Dr. Weaver. As you know, there has been a constant flow of information over the years between our two countries on housing. I recall that Dr. Weaver particularly, when he was secretary, came to Canada on several occasions to talk about housing, and we heard the gospel of housing according to St. Bob. And it was very helpful.

I have been following with a great deal of interest the proposals being considered by your committee for urban development corporations, together with proposals for block grants to State and metropolitan housing agencies.

I would like to refer to some of the Canadian housing programs with particular reference to the operations of the Ontario Housing Corp., which came into being on the first of October 1964. In fact, they will be having their seventh birthday in a couple of months. In some ways our programs are similar and there are facets in which they are quite different. Canada was one of the last of the Western civilized countries to adopt a subsidized housing program.

Legislation was passed in 1949 which permitted the Federal Government to enter into agreements with the Provinces to produce housing for low-income families, as well as to assemble land to permit homeownership for families in the low- to modest-income group.

Canada entered into this field reluctantly. The performance during 1949 to 1964 is a clear indication that this program was not popular at any level of government including the Federal, Provincial, and municipal governments. During this 15-year period Canada produced 9,000 subsidized housing units, the bulk of which was a full recovery type with the only subsidy provided being in terms of low-interest rate and long amortization terms. Of the 9,000 units produced 6,000 were built in the Province of Ontario. Then the situation became quite difficult. Canada became highly urbanized. In 1964 they felt the need to make a distinct change, which they did. Under the dynamic leadership of Hon. Stanley J. Randall, who was then Minister of Economics and Development, the Ontario Housing Corp. was formed. The first chairman of the Ontario Housing Corp. was the late Kenneth D. Soble, of Hamilton, who incidentally, made millions in the television business. He was vitally interested in promoting housing for lowincome families and gave a great deal of his time and effort in the area of social housing. In fact his tremendous efforts in this area, coupled with his other onerous business commitments lead to his complete physical breakdown, and his passing away was a sad loss to Ontario, and indeed to Canada.

The government of Ontario felt that no real headway could be made in this field unless one government took the full responsibility to proceed with the program. Accordingly, they directed that the Ontario Housing Corp. take on the responsibility for the following:

(a) Construction and management of houses for low- to modestincome families.

(b) Construction and management for the housing of senior citizens, as well as the provision of major land assembly projects. (c) The assembly of land to provide for fully serviced lots to be made available to modest-income families under leasehold arrangements.

In terms of the production of public housing accommodation, the Ontario Housing Corp. was the first agency in Canada to use the builder proposal technique, which I believe is better known in the United States as the "turnkey" program. No public housing project can be built in any municipality in Ontario unless a formal request is received from the municipal council asking that the Ontario Housing Corp. carry out a survey to establish need and effective demand. Following the survey, the corporation issues a proposal call inviting proponents to submit specifications of the projects on land owned or controlled by the private developer. Under this arrangement, the responsibility to secure the necessary municipal approvals in terms of zoning and municipal bylaws rests with the proponent.