statutory changes in debt and interest rate limitations; (3) collateral deposit requirements in municipal bonds for insurance companies; (4) direct issuance of low denomination bonds; and (5) public finance assistance departments.

During the last several years, we have witnessed a growing number of bills introduced in the Congress which would shift state and local borrowing from the tax-exempt to the taxable market. In most cases, federal agencies would act as intermediaries between state and local governments and the public in marketing municipal bonds. Regarding further Congressional action in this area, we recommend the following criteria:

1. Use of any federal credit assistance programs by state and local governments should be entirely voluntary.

2. Such assistance should be free of federal interference and intervention in matters of state and local concern.

3. Such assistance should be simple, dependable, and free of delay.

4. Such assistance should not be viewed as an alternative to federal grant assistance where the latter is appropriate and necessary.

The committee reasserts that such proposals should not in any way impair the access of state and local government to the tax-exempt market or infringe upon these governments' independence in debt financing.

In the past several decades, the tax-exempt bond market has become an increasingly important source for the long-term capital needs of state and local governments. Some $18.3 billion in new tax-exempt issues were offered by state and local governments in 1970. New issues will likely exceed $20 billion in the current year. These figures can be compared to the $3.5 billion in new municipal bonds offered in 1950. In 1969 and 1970, the states incurred debt to finance 38 percent of their total capital outlays. Cities and counties obtained 63 percent of their capital financing from debt issues.

Long term capital financing provides a number of distinct advantages to state and local governments. Bond issues spread the cost of facilities over the course of their useful life and between present and future users. In addition, the assistance provided by tax-exempt bonds is available to state and local governments at their own option with no federal controls.

Critics of tax exemption argue that it permits upper tax bracket individuals and commercial banks to escape their share of the tax burden and provides less aid to state and local governments in the form of lower interest rates than it costs the federal government in revenue. Based largely on these criticisms, the Congress has on several occasions attempted to curtail the exemption. The most recent of these attempts came in 1969. In that year, the House passed the Tax Reform Act of 1969 containing a number of provisions which would have resulted in the indirect federal taxation of the interest on state and local bonds. As a result of strong protests by Governors and other aroused public officials, these provisions were dropped in the Senate.

In the past, the main emphasis of policy adopted by the National Governors' Conference in this area has been to affirm the principle that state and local bonds must remain tax-exempt. However, in a significant new departure from past policy, the Conference in 1970, approved a position recognizing "the desirability of developing constructive proposals for broadening the market for state and local bonds."

The municipal bond market

There are a number of major factors to be considered in reviewing the current status of the state and local bond market with a view to further policy development by the Executive Management and Fiscal Affairs Committee in this area in 1971.

1. In the past, state and local bond issues have proved to be particularly sensitive to changes in monetary policy. In May 1970, during a period of extremely tight credit, the Bond Buyer Index of state and local bond yields hit a 75-year high. These periods of high interest rates raise substantially the cost of facilities which can be financed. Other projects must be deferred. Aggravating the situation are constitutional or statutory limitations on borrowing rates.

2. Holdings of municipal bonds are concentrated in the hands of a few classes of investors in high income tax brackets. In the period 1959-69, commercial banks and high bracket individual investors absorbed 87 percent of the net income in state and local securities, with commercial banks responsible for the major por

tion. Moreover, bank participation has been highly volatile. As a rule, in periods of expansive monetary policy banks will participate heavily in the tax-exempt market. In times of monetary stringency, however, banks tend to move out of the market and may even liquidate some of their tax-exempt bonds. As an example, commercial banks purchased 85% of new municipal issues in 1967, and about 70% in 1968; in the tight money year of 1969, bank participation averaged less than 17%, although at times banks were actually net sellers of municipal bonds.

3. The secondary market for municipal bonds is inferior to that for corporate bonds. The market is very limited to begin with, concentrated as it is around high income tax bracket investors. The market is further narrowed by the usual size of municipal bond issues: whereas corporate bonds typically are sold in large amounts with single maturities, making resale attractive, municipal bonds are customarily sold in relatively small amounts with several maturities.

4. Although it is difficult to speculate about future developments in the municipal bond market, there is a great deal of evidence to support the conclusion that the volume of nex tax-exempt bond issues in the 1970's will be much larger than in the 1960's. Such a development would likely bring new pressures on the tax-exempt market and of course interest rates.

5. Potentially one of the most significant developments in this area during the last several years has been the growing volume of proposed federal legislation designed to shift state and local lending from the tax-exempt to the taxable market. Most of this legislation proposes the creation of agencies to act as intermediaries between the state and local governments and the public in the marketing of municipal bonds.

In the near future, it is not likely that we will witness a direct frontal assault on tax exemption. However, the clear trend toward increased federal assistance to states and localities through taxable bond agency financing devices raises a number of serious issues for state government.

Recogniizng the problem areas in the present tax-exempt market, several proposals have been advanced to strengthen this important source of funds for state and local governments. These suggestions will be divided into (a) proposals to expand the market for state and local tax-exempt bonds and (b) proposals to restructure the municipal bond market.

Proposals to expand the market for tax-exempt bonds

1. Mutual Fund Regulation Change.-Under this proposal, an amendment to the Internal Revenue Code would permit mutual funds to buy and sell taxexempt bonds and pass interest income from these securities through to shareholders without incurring a tax liability. This proposal would make municipal bonds available to investors who find the typical $5,000 or higher denominations of these securities out of reach.

2. Unemployment Trust Fund.--The Unemployment Trust Fund consists primarily of state monies, maintained as separate state accounts, which are invested in U.S. Government obligations. At the end of fiscal 1969 the reserves of the Unemployment Trust Fund amounted to $12.6 billion and were growing by about $1 billion per year. About 80 percent of these reserves are held in the form of special issues at an interest rate of 44 percent. The proposed change is that the legal provisions governing the Fund be revised to allow limited investments in municipal securities. To overcome problems of selection, such investment might be restricted to those municipal obligations issued in conjunction with federal grant programs. Such an investment policy, had it been pursued during the period since 1960, would have helped to finance state and local facilities while not significantly affecting the return on the trust fund portfolio. Nevertheless, it is imperative that the investment authority of he Fund be broadened to allow an improved rate of return on the Fund investments. Proposals to expand the market for tax-exempt bonds also include initiatives at the state level which are entirely within the consideration of a state.

1. Creation of State Urbanks to assist local governments in obtaining an adequate supply of credit at reasonable rates of interest. Vermont has successfully established and operated such a bank. The bank assembles a group of local bond issues then sells an issue of its own equal to the total amount of the local issues plus a sum for the reserve fund. With the proceeds of its bonds the bank buys the local bonds. The bank retires its bonds as towns pay them off from tax reve

nues.

2. Elimination of certain constitutional and statutory debt and interest rate limitations, whereby the notice of sale would establish the maximum interest rate as determined by the State (Treasurer) in view of the prevailing market conditions.

3. Provisions regarding collateral deposits for insurance companies which make it attractive and/or imperative for those deposits to be in municipal bonds of the state.

4. Direct issuance, where feasible and beneficial, by state and local governments of a limited number of tax-exempt bonds in denominations low enough ($1,000 or less) to appeal to the smaller investor.

5. Public finance assistance departments within state governments, whose principal objective is to ensure the effectiveness of local financial management by:

Fostering more orderly debt marketing schedules by serving as an advance clearing agent for tentative bond offerings.

Publishing timely reports on subjects of special interest to finance officials. Providing educational seminars for civic officials at state and local levels. Public service advertising in the communities involved in bond financing—preelection efforts explaining the how and why of municipal bonds and/or postelection efforts in conjunction with the winning underwriter.

Discouraging the proliferation or survival of small and frequently overlapping special purpose units of government, and encouraging where indicated consoli- · dated general purpose entities with a stronger financial base and a higher borrowing capacity.

Voluntary contributions of expertise from the private sector (investment banking, bond analysis, et al) would allow even greater potential for effectiveness through this kind of state effort.

The preceding activities exist in various degrees in a limited number of states. Relevance and benefit may vary among states, but consideration of this sort of action is possible by many states, and reflects potential areas for state progress in solving problems of municipal finance.

Proposals to restructure the municipal bond market

There is a growing sentiment in Congress to restructure the municipal bond market. Proposals with this objective fall into three broad categories: first, proposals involving some form of federal government interest subsidy of fully taxable bonds issued by state and local governments; second, urbank proposals, under which federal government instrumentalities would serve as the financing vehicle for State and local governments; and third, proposals for a federal interest subsidy to pension funds holding tax-exempt municipal bonds.

In the last Congress, legislation dealing with FHA and Hill-Burton Programs created what amounts to small urbank operations and taxable municipal securities. In addition, Title I of the 1970 Housing Act allows States and localities to issue taxable bonds and receive a federal guarantee and subsidy. In the current session of the Congress, a number of bills have been introduced which follow a similar pattern. The Administration's proposal to create an Environmental Finance Authority and Representative Wright Patman's National Development Bank are two representative examples.

The Committee is concerned about increased fragmentation resulting from such activities. Although individual measures do meet specific needs, they tend to put pressure on the overall bond market as well as to form piecemeal solutions to public financing problems. The Committee, however, has developed a set of criteria for use in responding to federal initiatives in these areas.

1. Use of any federal credit assistance programs by state and local governments should be entirely voluntary. Such aid should not be made mandatory either directly or indirectly through program requirements or as a precondition for receiving other forms of federal assistance. Nor should it be used to accomplish objectives unrelated to expanding the supply of credit and lowering its cost to state and local governments. Steps should be taken to ensure that the conventional market will remain a viable alternative to all state and local borrowers. 2. Such assistance should be free of federal interference and intervention in matters of state and local concern. It should be generally and automatically applicable to all legitimate state and local debt transactions. To accomplish this, it should incorporate direct and immediate access to capital markets that state and local borrowers now enjoy, permitting them to choose the conventional or the alternative means at the very time they decide to borrow.

3. Such assistance should be simple, dependable, and free of delay. Any alternative, to be realistic, must not be subject to elaborate and costly procedures or the uncertainties of continuing administrative review and change. Program commitments should constitute on-going and irrevocable obligations by the federal government. To assure maximum benefit for the dollar of assistance, the mechanism for its implementation should be kept to a minimum. What procedures and provisions are necessary should be uniform and unified to avoid confusion and overlap.

4. Such assistance should not be viewed as an alternative to federal grant assistance where the latter is appropriate and necessary. A redirection of assistance to generate indebtedness on the part of state and local units will merely intensify the future financial problems and heighten the strains now experienced by all financial markets, including that for state and local obligations.

Senator PROXMIRE. Mr. Morris, we are delighted to have you. You might proceed in your own way. If you want to abbreviate your statement in any way, or read your entire statement, it is up to you.

If you abbreviate it, your entire statement will be printed in full in the record.

STATEMENT OF FRANK E. MORRIS, PRESIDENT, FEDERAL RESERVE BANK OF BOSTON; ACCOMPANIED BY PETER FORTUNE, ECONOMIST

Mr. MORRIS. I have with me Peter Fortune, who is an economist in our bank.

Senator PROXMIRE. We are familiar with the work of Mr. Fortune. Mr. MORRIS. Peter is the author of the econometric model that I will refer to in my statement. If you have questions on the model, I will have to lean on Mr. Fortune. I think my statement is short enough that I can read it, Mr. Chairman.

I am happy to have an opportunity to testify on behalf of S. 3215, which embodies, in my judgment, the best approach to broadening the market for the securities of State and local governments. Such a broadening of the market is essential if the capital needs of State and local governments are to be adequately financed in the decade ahead.

I should make it clear from the outset that I am testifying as a longtime 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.

I have had an opportunity to study the municipal bond market in the past 17 years from a number of vantage points, starting at the time I was research director for the Investment Bankers Association, and had a chance to view the market from the standpoint of the bond underwriter. Subsequently during the Kennedy administration, I was Assistant to the Secretary of the Treasury for Debt Management and had a chance to develop a Treasury point of view on this market.

Subsequently, I viewed the market from the standpoint of the investor as a vice president of a Boston investment counseling firm, Loomis, Sayles and Co., which buys a substantial amount of municipal bonds for its clients.

In my present capacity, I have been greatly concerned for several years that the municipal bond market, as it is presently constituted, has much too narrow a base to meet the rapidly growing financial needs of State and local governments.

Moreover, because of its extreme dependence on the commercial banks, the existing market is much too sensitive to changes in monetary policy.

All of us in the Federal Reserve are very much concerned about the uneven impact of a tight monetary policy on the various sectors of the economy. Two of the most prominent victims of a tight money market are housing and State and local governments. We are never going to eliminate this problem until we have learned how to control Federal Government fiscal policy more responsibly than we have in the past and until we adopt measures which will mitigate the wide swings in corporate investment. Nonetheless, I think we can do a great deal to improve the situation by strengthening the markets for the securities of the weaker claimants on the flows of funds.

We have done a great deal, I think, to strengthen the mortgage market and I think our efforts have met with some success. While housing did not escape the money squeeze of 1969-70, the contraction in housing starts was, I think, substantially less than it would have been had we been operating with the same mortgage market that we had in 1966. But so far, we have done nothing to improve the structure of the municipal bond market. I think, in fact, our efforts to help housing in 1969 probably had the effect of putting more pressure on the State and local market.

S. 3215 would create a dual market for municipal bonds. The taxexempt market would continue to function, but the volume flowing through it would be reduced and the yields on tax exempt bonds would be lower. The breadth of the impact of the dual market will be directly related to the level of the interest subsidy paid on taxable bonds. With a one-third interest subsidy in a tight money year like 1969, taxable bonds would amount to 20 to 25 percent of the total volume of new issues, with the volume of taxable bonds under a one-third subsidy falling off to about 10 percent of the market in an easier money year such as 1968. The principal contribution of the taxable municipal market in a relatively easy money year would be to act as a safety valve for periods of congestion in the tax-exmpt market.

As I will indicate later on, my only concern about the bill as it is now written is that the subsidy level is too low. I think it ought to be 40 percent instead of 33.

The starting point in assessing the costs and benefits of the bill is the recognition that we would then have two Federal subsidies in operation in the municipal bond market: The subsidy given indirectly through tax exemption, and the subsidy given directly on municipal bonds under this bill. One of the most constructive aspects of this bill is that it would improve the efficiency of the subsidy given through tax exemption by automatically preventing an overloading of the taxexempt market.

I think there is a lot of room for improvement in efficiency of the subsidy we have. As you know, the Treasury estimated that in fiscal 1968, the cost of tax exemption to the Treasury was $1.8 billion, and the benefits to State and local governments $1.3 billion, with a residual of $500 million accruing to the benefit of high-bracket investors, commercial banks, and casualty insurance companies.

Now recently, Harvey Galper, who will be testifying later, estimates that in fiscal 1971, the cost of this existing subsidy to the Federal