would otherwise be financed with tax-exempt bonds would be 42 percent of the interest paid on the taxable bonds. That analysis was based on the assumption that the interest on all new municipal borrowings would be subject to Federal income taxation. S. 3170 presents a somewhat different analytical problem in that it requires an estimate of increased Treasury revenue from taxable municipal bonds under circumstances in which States and localities would have the option of issuing tax-exempt bonds or issuing taxable bonds with a Federal guarantee and interest rate subsidy. On the basis of our preliminary analysis, however, it appears that the current impact on Treasury revenues would not be substantially different under either approach.

We would agree with the thrust of your staff analysis that the increased Treasury revenues from substituting taxable for tax-exempt bonds will arise from the increased taxes paid by those high bracket investors who would have purchase the tax-exempt bonds but, because of the reduced supply of tax-exempts, are required instead to expand their holdings of taxable instruments.

As your staff analysis indicates, the principal purchasers of tax-exempt securities are commercial banks, and the reduced volume of tax-exempt securities resulting from S. 3170 would tend to result in increased commercial bank investment in business loans and other taxable loans and securities eligible for commercial bank investment.

Holdings of State and local securities by insured commercial banks increased from $17 billion in 1960 to $50 billion in 1967. Almost completely as the result of this increase in holdings of tax-exempt securities and the decrease in the top corporate tax rate from 52 percent to 48 percent, the effective rate of Federal income tax paid by insured commercial banks declined from over 38 percent in 1960 to less than 24 percent in 1967. On the basis of our preliminary analysis these banks would have paid approximately $2 billion in Federal income taxes in 1967, rather than the $1 billion actually paid, were it not for their holdings of tax-exempt obligations.

The dominant role of commercial banks in the municipal bond market appears to be the major determinant of interest rates on tax-exempt obligations. Since commercial banks are primarily in the business of making loans—they are not significant investors in corporate bonds-they apparently seek a rate on taxexempt bonds which is approximately equal to the after tax return available on loans.

Thus, because of the tax exemption, municipal bonds are attractive only to high tax bracket investors, such as commercial banks, and, thus, State and local borrowers are forced to compete with demands for bank loans at significantly higher levels of interest rates than prevail on corporate bonds. The dependence on bank investors is also a fundamental consequence of the fact that tax-exempt securities are issued by a wide variety of local governmental units. These appear to be the essential obstacles to reducing the level of interest rates paid by States and localities on tax-exempt borrowings.

The argument that the increased Treasury revenues from S. 3170 would be relatively small initially or over the long run is apparently based on the assumption that low tax bracket investors, such as State and local retirement funds and life insurance companies, would be prompted to switch from tax-exempts to taxable securities. As your technical analysis indicates these investors have for a number of years been net disinvestors in municipals. The legal, institutional, and other reasons for past investment in tax-exempt bonds by these low bracket investors would presumably not be affected by S. 3170. Consequently, the revenue estimate should clearly not be based on assumptions with respect to the tax brackets of investors who purchase the new taxable municipals generated by S. 3170.

Thus, we believe that the revenue estimate made in 1966 is applicable to the present problem. The Treasury would gain in revenue more under your proposal than the cost of the interest subsidy.

Sincerely yours,

WILLIAM F. HELLMUTH, Jr.,
Deputy Assistant Secretary.

Senator PACKWOOD. In your statement, you suggest that EFA might be involved in one out of five bond issues.

Are there presently 20 percent of our communities that are unable to participate in Federal grant programs for water pollution con

trol because they can't meet local share requirements or for other defects?

Mr. VOLCKER. One out of five is based upon a presumption, Mr. Chairman, that the test of reasonableness in terms of rate and market access is met at about a BAA credit rating standard. When you get in that area, it begins putting a significant burden on the State and local governments, and may be for that reason a reasonable test of reasonableness and about one out of five issues fall into that category or lower credit rating.

If we operated on that basis-and there is a presumption in that statement that we would operate on that basis-you get about one out of five issues.

Senator PACKWOOD. I won't ask you specifically to state their objections, but as you are aware, the EFA proposal is opposed by investment bankers.

Could you speculate as to the general reason for their opposition? Mr. VOLCKER. Well, there was, I think, some feeling perhaps by part of the investment banking community, that any program which removed some securities potentially from the tax-exempt market into the taxable market on a consolidated basis would cut into the business of tax-exempt underwriters and bond dealers, and they are concerned about establishing that principle.

I think the principle has been established in other areas where the Federal Government has a direct interest, and I think this is what they overlook or what I would argue in response to their concern, that this is a program where on the face of it, the Federal Government is providing subsidies of some 30 to 55 percent, as I recall it, and when you have that much Federal involvement in the program, obviously you have a degree of Federal control and interest that justifies this kind of treatment.

It is not a program—and I think this is probably the basic concern of the investment banking community-it is not a program which implies any precedent that I see for a general encompassing of the tax-exempt bond market into taxable or consolidated form.

It deals with a very limited sector of the market where there is already heavy direct Federal involvement.

Senator PACKWOOD. Mr. Secretary, clarify, once more, how you are going to assure this committee that EFA is only used when local public bodies are really unable to sell their issues under reasonable financing elsewhere.

Mr. VOLCKER. As this legislation is drawn, that substantive decision is up to the Environmental Protection agency.

The real protection in the end, I think, Mr. Chairman, is simply a State or a local government would have no incentive whatsoever to come to EFA unless he can get a cheaper rate at EFA than he could in the market.

So, what is in a sense the controlling factor here after and beyond the Environmental Protection agency itself pronounces judgment is the rate which is set on the issues by EFA, and that rate, as I indicated here, in clarifying our intent, would be something around a BAA area of municipal bonds.

The ultimate protection in the end is, I think, the lack of any

incentive for a State or municipality to come to EFA if it can do better than that in the market.

Senator PACKWOOD. I suppose EFA has no great desire to undertake more obligations than necessary, because I am presuming you are going to have more demands upon your financing capacity, than you have available resources.

Mr. VOLCKER. We would have no feeling of urgency to do more. The intent of the legislation is exactly the opposite.

We want to meet the criticism that there is a hole, in a sense, in the program, the argument that some few municipalities may not be able to participate fully in the Federal program even with a large subsidy because their financial position is so weak they can't even borrow the residual portion, and it is only to meet that problem that we propose this at all. But we think that is a significant problem, that municipalities in a weak financial position have pollution problems, and they should not be excluded from the pollution program by virtue of their weak financial position.

So it is only to plug what we think is a limited gap in the armor of instruments we have here. We don't want to do any more financing than we have to.

Senator PACKWOOD. In the past, Mr. Secretary, didn't the Treasury recommend that a system be established under which local and State governments could issue taxable securities, coupled with a Federal subsidy, instead of tax-exempt securities?

Mr. VOLCKER. Have we ever proposed such?

Senator PACKWOOD. Yes.

Mr. VOLCKER. As a general proposition not to my knowledge. Certainly this administration has not, Mr. Chairman, but I don't think previous administrations have ever made that general proposal either.

Senator PACKWOOD. Mr. Secretary, you say that you are not prepared to make recommendations at the moment on S. 3215.

Would you give this proposal your careful consideration and give us your recommendations as soon as possible on it?

Mr. VOLCKER. We certainly will give it our consideration, Mr. Chairman, but I think I should say that we can see a number of broad issues in this kind of approach that to some degree certainly trouble

us.

It does, I think, raise some important issues of what the relationships between the Federal Government and the State and local governments will be.

When you provide this kind of direct subsidy for their obligations, the implication may be at some time down the road this could be used in a way to influence more directly the nature the State and local government programs.

I think some of that is already implicit in the bill in that the subsidy is not available to every type of State and local government issue. It cites a broad category, but still a limited category, of issues for which it would be available.

You get into that kind of a problem.

You get into another series of problems as to setting the appropriate level of the subsidy, and you are rather torn between a level that makes

it effective in terms of making it useful, and a level that doesn't cost the Treasury a lot of money.

You have the question of tax equity, and I think it is questionable whether this kind of voluntary program provides much help in the tax equity area.

So, there are some very large basic issues here to which I think the answers are not at all apparent. But we will certainly look at it. Senator PACKWOOD. What do you foresee as the role for Federal credit agencies, generally?

Are they likely to expand the proportion of the Nation's credit resources that they now control, and what implications will their future roles have for private borrowers and State and local governments?

Mr.VOLCKER. One can only look at the past record, Mr. Chairman, and I think that record has been one of explosive expansion to the point where certainly in my mind, it raises some questions as to the desirability and availability of that trend continuing.

As I indicated in my statement, projecting ahead to fiscal 1973, something like half of all the credit going through the economy will, in effect, be channeled through Government hands.

Mr. Snyder just gave you a chart. I have a chart both in dollar volume and in percentage amounts. I am not sure which he showed

you.

The percentage chart shows that in fiscal year 1963, 22 percent of all credit was federally assisted or Federal in one sense or another. In 1973, the figure is 49 percent.

It is not quite clear what is big enough or what is too big in this area. I think you can say without any contradiction that is a big percentage. It is a big enough percentage to raise very serious questions.

I think it is something the Congress ought to look at, very frankly. The problem in this area, Mr. Chairman, is that anyone looking at one particular substantive area and responsible for one particular substantive area, is naturally inclined to deal with the problems in that area and increasingly to deal with them through a credit program.

That appears convenient. It doesn't use any budgetary money. It is kind of an illusion, that the credit markets are very large, the particular program you are dealing with looks small relative to the total credit markets, what will it hurt to put some more demand on that market?

And you get a proliferation of this approach in housing, in State and local governments, in pollution, in student loans, in export credits in merchant marine bonds, in TVA in rural electrification. You name it, there is a program, and it comes into the credit markets.

I don't object to that looked at individually, but I also say, let's look at the total, look at what we have wrought in total, because every time you do this you are putting pressure on the rest of the market, and I think there is a need to look at the total, to focus on the total, to decide where we want to go in the light of the overall demands in the market, the competing demands by other Federal agencies, the competing demands by private borrowers.

We get ourselves in a ridiculous position where to meet a problem,

we push one agency after another, or one program after another, into the credit markets, and then the next year we turn around and, my goodness, we don't have enough money for housing in the private

markets.

Of course you don't, when you have pushed all this other demand into the credit markets.

So, we have to look at that kind of problem and look at our overall priorities, and one of the benefits of this kind of legislation, we would hope, is precisely to focus attention on the total without prejudging the issue as to whether it should go up or down.

We ought to at least look at whether it should go up or down in light of the overall problem.

Senator PACKWOOD. Let me ask you this last question.

Look down the road a few years, let's say EFA is passed, isn't there going to be a tendency for Congress to ask EFA to buy not only the hard-to-market bonds, but eventually to buy any local waste treatment bonds. Also, if this is a likely prospect, what is going to be the impact on such a movement for the interest exclusion of State and local obligations?

Mr. VOLCKER. I would think the net impact, looking at in terms of EFA which would be a very small program, or looking at it in terms of the Federal Financing Bank, which would be a large program in terms of financing volume, I think the impact of this as a byproduct would be to relieve some of the pressures on the municipal market, the traditional municipal market. Some of the growth areas in which the Federal Government already has a very large interest, would be diverted into the taxable market.

What this means is the pressures that many people foresee, I think with some accuracy and some reality, on the municipal markets, would be alleviated so you make it easier for State or local governments to borrow for traditional purposes in the tax-exempt market, by relieving the burdens on that market.

So, I would rather hope and expect that the result would be precisely the opposite of what you suggest: by relieving the pressures on the municipal market and in a not insignificant way, that market will be able to continue to function effectively and therefore to meet the traditional needs of State and local governments where there is not a heavy Federal involvement.

The philosophy on this, to be quite clear, just to repeat, we are interested in either the EFA proposal or the Federal Financing Bank proposal, in dealing with State and local government issues only where there is already a heavy Federal involvement. Those are the only securities we are talking about.

Where there is no Federal direct involvement, those securities are not touched, they are left for the traditional tax-exempt State and local government bond market.

Senator PACKWOOD. But in the most hard pressed of all municipalities, those up against their debt ceilings and that cannot get their voters to pass a new bond issue, EFA will not be able to enter into this because the municipality will not be able to guarantee repayment. Mr. VOLCKER. In the EFA area, the idea is that the Environmental Protection Agency itself will guarantee the issue. So in that case, they could enter in.