Second, in contrast to the present fragmentation of financing efforts, the new institution would automatically provide for coordination of issues and control over programs requiring finance. Thus, a central financing institution would have the greatest flexibility in going to market at the best time and with the volume, maturities, and other terms and conditions which would enable it to borrow at a significantly lower interest rate than could be obtained by several smaller, special purpose institutions, each with its own special problems of timing, seasonal factors, and other program considerations.

I do not think, incidentally, that the answer to the financing problems over the next decade will be to establish a separate new institution for each problem area, such as an education bank, a pollution control bank, a transportation bank, etc. The difficulty with this approach-in addition to the duplication of effort and the problem of finding that much financing talent-is the proliferation of financing instruments which would develop and the problem of coordinating these issues in the market. Of course, even a central financing institution could decentralize its lending activities, either in terms of loan purpose or geographic region. But I think there is a persuasive case for a centralized approach to mobilizing capital funds.

Third, the new approach permits the most economical financing of the growing new needs, looked at either from the viewpoint of the Federal Government or from the viewpoint of State and local governments.

If all of these new needs were to be financed in the tax-exempt municipal bond market, which, by its very nature, is limited in capacity, the additional volume of financing would tend to have the effect of significantly increasing State and municipal borrowing costs, not only for these new programs but across-the-board for all State and municipal government programs. The proposed new institution would avoid these problems by operating in a far broader market. The net cost to the Federal budget, moreover, would be minimized through the use of the proposed development bank, which would issue taxable securities.

These considerations give the Federal Government and State and local governments a community of interest in finding the financing means that will be most economical for all levels of government combined. And I am confident that means can be found which will not impinge in any way on the ultimate fiscal independence of State and local governments, which now rely mainly on the taxexempt concept.

Some implications for capital markets

Even if the burgeoning new needs that we now envisage are financed in a much more efficient fashion than is now the case, such financing will be bound to have a major impact on capital and securities markets generally. Added to continuing large private requirements-and notably the likelihood that new housing needs will exert much greater pressures on the general capital markets than in the past-it will almost certainly mean that the average level of longterm interest rates will be higher than in the 1950's and early 1960's, when they were quite low.

This is not to imply that rates will not come down from their very high recent levels. But it does raise questions as to how long we can afford to continue accepting attitudes and practices that were essentially developed in periods when average interest rates were substantially below the levels indicated for the future. It suggests that continued maintenance of the statutory 414 percent ceiling on long-term Government bonds could become an increasingly troublesome obstacle to sound Federal debt management.

CONCLUDING COMMENT

So there you have the short and long of it. For the short-run, the pressure of Federal finance demand will diminish sharply, with consequently less pressure on interest rates. Over the longer run, the needs for social welfare infrastructure will place very heavy demands on the capital markets.

I welcome the lessened short-run pressure and wish my successors well in meeting the hard financial problems of the future.

EXCERPT FROM REMARKS BY HON. FREDERICK L. DEMING, UNDER SECRETARY OF THE TREASURY FOR MONETARY AFFAIRS, AT THE 50TH ANNIVERSARY CONVENTION OF THE AMERICAN GAS ASSOCIATION, PHILADELPHIA, PA., OCTOBER 7, 1968

FINANCIAL PROBLEMS OF THE FUTURE

During the next ten years, two major problem areas of finance will challenge the best efforts of the United States and one, perhaps both of them, will require concentrated attention by other advanced countries of the world.

For the United States, the first problem-bigger by far than the second in terms of financial requirements is to find ways to provide capital finance for public purposes designed to strengthen and improve what might be called social welfare infrastructure. By this term, I mean urban redevelopment, the renovation of the ghettos, the provision of public housing, the enlargement of public education and health facilities, the restructuring of transportation facilities, the provision of clean water and air.

In one sense, the problem is not a new one; in a more realistic sense, it is a brandnew one by virtue of its recognition and by virtue of the very size of its financial requirements. Let me give you some indication of its size.

Net State and local debt in 1947 was less than $15 billion. Last year, it was $113 billion-almost $100 billion larger than 20 years earlier. Mere continuance of that trend would make it $240 billion ten years from now. Add in the new programs noted above, and it is not difficult to visualize another $150 billion requirement. It is clear that requirements of this order of magnitude will demand the most efficient, imaginative, and sound means of mobilizing capital that we can devise.

I have spoken elsewhere of one approach to this problem-a National Urban Development Bank. Other suggestions have been made for a Municipal Bond Guarantee Corporation; for a Community Development Bank; for a Domestic Development Bank. Each is aimed at the basic objective of providing an efficient means of mobilizing the Nation's capital resources. We shall need to come to a consensus on a particular approach.

That approach should embody two basic principles:

Development of one efficient marketing instrument with broad investment appeal.

Coordination of issues and control over programs requiring finance.

A development institution would issue its own securities, backed by Federal guarantee, and relend the proceeds to program agencies either Federal lending acencies or directly to State and local agencies, depending on Congressional decisions as to individual program structure and control. Aside from the Federal guarantee, which would help marketing and minimize interest costs, a Federal Government contribution, to the extent necessary and desirable, could come from interest rate subsidies clearly identified-provided by direct Congressional appropriations.

The second problem, which will affect both the United States and other advanced countries, is to find ways to provide increased developmental capital finance for the less-developed countries of the world-both for infrastructure and for expansion of the agricultural and industrial base.

The financial requirements for the United States, or for any other country, are significantly less than those for domestic social welfare infrastructure, but there are other problems-perhaps most notably the balance of payments problem. Methods must be devised to fit these financing needs into the balance of payments adjustment process so that, when a country is in surplus, it can export more capital to developing countries, and when in deficit, it can export less. At the same time, it is desirable to increase the total amount of capital export and assure that volume for a period of time.

The United States proposed an approach of this type in the current replenishment of funds for the International Development Association. The Organization for Economic Cooperation and Development, composed of some twenty countries, suggested, in a 1966 report on the adjustment process, that surplus countries open their capital markets more freely to borrowings by international financial

institutions, such as the World Bank or the regional development banks. Both of these approaches need further development and implementation through international agreement. Both will lead to more multilateralization of development finance, which should be more efficient, both in terms of raising the capital and in terms of channeling it where it can do the most good.

Finally, I should note two points. Both of these financial problems-domestic social welfare infrastructure and development finance can be resolved only within a framework of a strongly expanding domestic and world economy. That is an absolute requirement to generate the savings and the tax revenues for the needed finance. And growing economies, themselves, need the thrust of dynamic new investment, which, itself, requires high savings.

REMARKS BY HON. STANLEY S. SURREY, ASSISTANT SECRETARY OF THE TREASURY, BEFORE THE FIFTH MUNICIPAL CONFERENCE, INVESTMENT BANKERS ASSOCIATION, NEW ORLEANS, LA., SEPTEMBER 27, 1968

THE FINANCING OF NEW SOCIAL PROGRAMS-AND TAX EXEMPTION

The Investment Bankers Association is to be congratulated on staging this forum on "The Federal Government's Role in State and Local FinancingTaxable or Tax Exempt?" The topic is one of direct and important concern to many-the Federal Government, State and Local Governments, those who invest in securities, and those like yourselves who participate in the marketing of securities. Unfortunately, most discussions which involve the sensitive subject of Federal-State relationships and the super-sensitive aspect of that relationshiptax exemption for State and local securities-proceed with a maximum of emotion, accusation and platitudes and a minimum of hard, objective analysis. Your desire for a forum with just the opposite approach is commendable and I trust my remarks will be seen as in keeping with your desire for they certainly are so intended.

At present there are about $120 billion of outstanding State and local taxexempt obligations and about $15 billion in new obligations are being issued annually (for a $9 or $10 billion net annual growth). I am not discussing these obligations or the merits of their tax exemption. I am not here to turn back any clocks or reverse history. I am here to consider what will happen if the clocks suddenly start to race madly forward.

My remarks relate to the enormous increase in new issues of these obligations that now looms up before us and the effects of adding this new huge volume of tax-exempt obligations to the present market. My concern and my message can be briefly summarized:

The possible high level of new issues of tax-exempt State and local bonds over the next decade raises very serious problems for State and local governments and for the equity of our Federal tax system. This high level can come about under the enormous financing requirements of the vast social programs so vitally necessary to meet our domestic needs.

The basic problem is that piling more and more reliance on the tax-exempt privilege as a way of helping States and localities to meet these financing requirements creates a powerful buyer's market for tax exempts. The State and local governments pricing their bonds on the basis of this exemption as a consequence will get less and less for it-that is, they will have to pay closer to the market rates of interest on taxable bonds--and their financing costs must inexorably rise. At the same time, the buyers would still get the tax exemption with even greater tax savings.

Those who are anxious to preserve the strength of State and local governments in the Federal system should give serious thought to these problems.

We should all consider whether new financing techniques are available and appropriate to avoid these problems-techniques which at the same time, and I stress this, preserve the independence of action on the part of State and local governments in our national system to which the principle of tax exemption has contributed.

Projections of State-Local Credit Demands

Let us first consider the rate of growth of new State and local issues that looms ahead. The Joint Economic Committee in 1966 made a projection of the likely level of growth capital needs and thus of State and local bond issues through

1975. The JEC figures themselves suggested that this growth would be in line with the likely growth in GNP. Since the supply of savings should also grow at about the GNP rate, the general conclusion would be indicated that the marketability of State and local bonds should not change markedly relative to other bonds.

But the Joint Economic Committee report itself emphasized one reservation about this outlook, namely, the heavy reliance placed on commercial bank takings. They recognized that if commercial banks, for example, were attracted more heavily into mortgages (e.g., by the much touted housing boom of the 1970's) there would be problems for State and local governments in floating even a level of State and local issues that was growing in line with GNP.

Another set of qualifications should be added to this forecast of marketability of State and local bonds. The JEC projections basically assumed a development of current programs. They did not make much allowance for new programs.

The expansion of Federal programs that lies ahead is likely to induce even more substantial increases in State and local government borrowing than may have been anticipated in the study. The Congress has already considered a wide range of new Federal programs in a variety of areas, such as pollution control and housing. In addition, pressures on the Federal budget have recently caused attention to be focused on the potentialities of debt service grants to State and local governments, as are now used in the public housing area, rather than the lump-sum grants that have been more traditional. From a financial viewpoint, these debt service grants would shift the financing of the Federal share of local project costs from the taxable market (i.e., away from the Federal bonds that provide the funds for the lump sum grants) to the tax-exempt market to absorb the local bonds that would be issued to finance the project (the debt service grants would help defray the interest and principal on these tax-exempt bonds). Another factor that may well have been underestimated in the JEC work is the size of replacement needs. For example, much of the physical plant in our urban school system is aged and inadequate to the school needs of urban children. Replacement will be very expensive. These replacement needs alone could cause the annual net increase in State and local bonds to double in the next five to ten years.

In summary, the growth of new programs especially Federally aided ones, the increasing reliance on debt service grants to shift Federal debt to State and local debt, and exploding replacement needs could increase the annual net growth in State and local debt from the present $9 or $10 billion as high as $30 billion a year in 10 years. This would represent a rate of growth twice as high as the rate of growth of the savings supply.

If State and local governments are to sell this enormous increase in tax-exempt bonds, then they will be commanding a larger share of the savings flow. To do so they will have to compete more sharply with other borrowers, such as home owners and corporations. The question is whether tax exemption is an efficient instrument with which to conduct this competition. We can take as a fact of life the exemption on tax-exempt bonds in the present market. The experts say that this exemption is "inefficient" in the sense that State and local governments get less benefit from it in lower interest costs than the Federal Government gives up in lost tax revenues. As I said earlier this could, however, be regarded as the price paid for the independence of decision-making that the interest exemption offers in general to State and local governments. What we need now to do, however, is to give serious thought to the question of how this will work out if State and local governments suddenly try to become much heavier borrowers.

The Market for Tax-Exempt Bonds

To understand the significance of this enormous potential growth in tax-exempt bonds, it is necessary to remember that the institution of tax-exempt interest has an impact not only on Federal tax returns but also on bond markets. It does save State and local governments money by reducing interest rates on their bonds, but it does so by narrowing the range of customers for those bonds. It narrows the range to groups that find tax exemption valuable. You don't find exempt pension trusts buying tax-exempt bonds.1

The rate on tax exempts is determined, like any other price, by demand and supply. If the supply of tax exempts is limited, they can be sold to the buyers

1 Tax-exempt entities have purchased tax-exempt obligations in the past and still do because of legal limitations on their investment powers. These limitations, however, are rapidly being removed.

who are most anxious to get them. If more tax exempts are to be sold, the price of those tax exempts will have to fall, i.e., their interest rate must increase. The price fall will be necessary to get existing buyers to take more tax exempts (and thus less of other investments) and to induce new buyers to enter the tax-exempt market.

It is significant that interest of all kinds-taxable and tax exempt together— is a modest component of the income of upper income individuals. That income consists mostly of dividends and capital gains, reflecting the fact that the wealth position of these individuals inclines them to the higher risk-higher return features of equity investment (which features are also associated with favorably taxed capital gains and untaxed unrealized appreciation). Inducing these investors into the relatively safe investment of State and local government bonds through tax exemption is in a sense swimming against the tide.

By and large since the most distinctive feature of these State and local bonds is their tax exemption, the process of selling more bonds must involve widening the market by appealing to taxpayers with lower marginal tax rates than those now acquiring tax-exempt bonds. The appeal must involve the process of selling tax-exempt bonds at rates more closely comparable to those on taxable bonds, so as to make the exempt bonds attractive to those who get less tax advantage from the exemption.

The Inevitable Increase in Interest Rates on Tax Exempts-and Higher Costs to Local Governments

It is not possible to say exactly how much tax-exempt bond interest rates would rise with an increase in the relative share of tax exempts in the market. Obviously, it depends for one thing on the levels of general interest rates, which are subject to a great many forces. We can make some progress if we assume the present level of rates and talk about the differential between high grade municipals and high grade corporates. Presently, high grade municipals sell at close to 70 percent of the rate on similar high grade corporates.

In 1945-46 the level of outstanding municipals, as well as new municipal issues, was very low. Municipals constituted only 3.2 percent of net public and private debt, and the interest yield on outstanding municipals was only 40 percent of the yield on corporate Aaa bonds. By 1954 the State and local indebtedness had risen to about 5.8 percent of net debt, and the yield ratio had risen to 70 percent of the corporate bond yield. The yield ratio has hovered about this level since 1954, rising to about 80 percent in 1957 and averaging about 67 percent in JanuaryAugust, 1968. The large item accounting for the recent pattern of a wider spread despite a still increasing State and local debt share (now 8.0 percent of net debt) is the sharp growth in holdings of municipals by commercial banks (associated with some pause in the growth of demand for mortgage money between the immediate post-World War II housing boom and the coming housing boom that will be associated with the World War II baby boom) and the unusual spurt in corporate bond flotations.

I am including a Table-Table 1-that presents some estimates of the possible response of the State and local bond rate to future developments. The table covers a range of possibilities respecting the size of State and local borrowing and the role of commercial banks in the market, since they are now the dominant institutional investor in municipal bonds. The future course of that role is of obvious importance can the banks continue that role, keeping in mind that business loans are their primary function? What happens when they reach the limits of their taxable income, as some are now doing, so that the use of expenses, in fact allocable to tax-exempt issues, against taxable income as now permitted no longer produces tax savings?

Table 1 shows that the interest rate increases resulting from a high volume of tax-exempt securities could be put as likely to be about one-half point (keeping in mind that it might come to a full point). At current levels of State and local debt issuance ($15 billion gross) this would mean an increased anual interest cost of around $75 million on one year's issues. This annual cost would of course cumulate if the increase persisted for subsequent new issues. With new issues rising at 10 percent a year, a persistent increase in the State and local bond interest rate of one-half point would increase the annual cost by about $500-$600 million in seven years. This increased cost, remember, does not include the increased debt service itself, which would be something in addition. The increased cost is just the cost of the interest rate increase caused by the increased debt. It is the increase in cost caused by going to the well too often.

This is a substantial burden to put on local property taxpayers.