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Federal Reserve Bank of Philadelphia
ISSN 0007-7011
NOVEMBER-DECEMBER 1978
i fi: i Hi s liii
!
i
1
Recent Experience
and the
Traditional
View
Coming:
A New Phase
for Regulation Q
&
Upward Biases
in Government
Spending ?
NOVEMBER/DECEMBER 1978
COMING:
A NEW PHASE FOR REGULATION Q
A Commentary by Edward G. Boehne
BANK DIVIDEND CUTS:
RECENT EXPERIENCE
AND THE TRADITIONAL VIEW
Howard Keen, Jr.
. . . Recent studies show that cutting dividends
may not hurt banks nearly as much as many
bankers have feared.
UPWARD BIASES
IN GOVERNMENT SPENDING?
Anthony M. Rufolo
Federal Reserve Bank of Philadelphia
100 N orth S ixth Street
(on Independence M all)
Philadelphia, P ennsylvania 19106
The BUSINESS REVIEW is published by
the D epartm ent of Research every other
m onth. It is edited by John ). M ulhern, and
artw o rk is directed by Ronald B. W illiams.
The REVIEW is available w ithout charge.
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sam e address, or telephone (215) 574-6426.
* * * * *
The Federal Reserve Bank of Philadelphia
is p art of the Federal Reserve S ystem —a
System w hich includes tw elve regional
. . . In principle, cost-benefit analysis should
improve government spending decisions, but
difficulties in carrying the analysis through
may produce a tendency toward overspending.
banks located throughout the nation as well
as the Board of G overnors in W ashington.
The Federal Reserve System w as e sta b
lished by Congress in 1913 prim arily to
m anage the natio n ’s m onetary affairs. Sup
porting functions include clearing checks,
providing coin and currency to the banking
system , acting as banker for the Federal
g o v e rn m e n t, s u p e rv is in g c o m m e rc ial
banks, and enforcing consum er credit pro
tection law s. In keeping w ith the Federal
Reserve Act, the System is an agency of the
Congress, independent ad m inistratively of
the Executive Branch, and insulated from
p artisan political pressures. The Federal
Reserve is self-supporting and regularly
m akes paym ents to the U nited S tates
T reasury from its operating surpluses.
COMING:
A NEW PHASE FOR REGULATION Q
By Edward G. Boehne, Senior Vice President
Federal Reserve Bank of Philadelphia
failures of the 1930s, although later research
has failed to substantiate this claim.
The authority for placing interest rate
ceilings on time and savings deposits at
commercial banks and thrift institutions,
generally referred to as Regulation Q, is due
to expire in December. Although renewal
has become almost routine, there is still a
good deal of concern about w hat the longer
run future holds. Will the differential be
elim inated? Will ceilings be phased out?
There is a tendency to forget that Regulation
Q is not w hat it once was nor is likely to be in
the future w hat it is today.
PHASE II
Phase II runs up to the mid-1960s. Regula
tion Q ceilings in this period were thought of
more as an instrum ent of m onetary control, a
dusted-off tool for the new era of active
countercyclical policy. Bank credit could be
limited, it was reasoned, if banks were kept
from competing for funds during periods of
monetary restraint. Bank credit, indeed, could
be limited, but total spending could not,
because alternative sources of credit were
used to circumvent Regulation Q. Mortgage
credit, in addition, w as hard hit by the
combination of rising interest rates and rate
ceilings, thus raising the social and economic
cost of m onetary restraint.
PHASE I
Phase I began with the inception of Regu
lation Q in the 1930s and runs to the 1950s.
The original philosophy of interest rate ceil
ings was to protect the banking system from
unprofitable rate competition by limiting
what could be paid on deposits. “Destructive”
rate competition in the 1920s was believed by
m any to have helped precipitate the bank
PHASE III
Phase III dates from these lessons of the
3
NOVEMBER/DECEMBER 1978
BUSINESS REVIEW
mid-1960s. Since then, interest rate ceilings
on time and savings deposits have been
associated more w ith helping housing by
making mortgage money available at thrift
institutions. A big step in the evolution of
Regulation Q was the general realization that
housing and hom eowners could be helped
more by letting ceilings rise rather than by
holding them down during periods of credit
restraint. Higher ceilings allow thrifts to pay
more competitive rates and to increase the
supply of funds to mortgage borrowers. High
er rate, available mortgages finance more
houses than lower rate, unavailable m ort
gages.
Higher Q ceilings, however, raise costs for
thrift institutions substantially faster than
thrifts themselves are able to raise revenues.
Unlike commercial banks, which generally
have more diversified loan portfolios with
shorter maturities, thrifts m ainly have fixedrate mortgages with lengthy m aturities. The
unhappy tradeoff with ceilings in Phase III
has been between protecting the strength of
thrift institutions and m aintaining an ade
quate flow of mortgage funds. Too high a
ceiling (or no ceiling), it is argued, weakens
thrifts, and too low a ceiling causes mortgage
funds to dry up.
Most of the changes in Regulation Q during
the past dozen years, plus some other gov
ernment programs to support home financing,
have been aimed at trying to strike a better
balance between ceilings that are “too high”
and those that are “too low .” Ceilings have
been raised (eliminated for large denomina
tions), maturities for time deposits lengthened,
special certificates introduced, direct lending
to thrifts substantially increased, and a thriv
ing secondary m arket for mortgages devel
oped, among other actions. As a result,
mortgage funds have not evaporated and
housing has fared much better during the
current period of rising interest rates than
during similar periods in the past. In addition,
the wider variety of savings instrum ents at
thrifts and banks has enabled the small saver
to take better advantage of higher yields.
PHASE IV
Phase III is fading into a new Phase IV as
financial institutions become more homoge
nized. As now written, Regulation Q allows
thrift institutions to pay a premium rate on
most time and savings deposits. The justifi
cation for this differential is that thrifts need
an advantage in order to compete with banks
that traditionally have offered a wider variety
of services. To the extent that thrifts gain
broader lending powers and w hat amount to
checking accounts, the case for preferential
treatm ent diminishes. It would make more
sense, if one is searching for a rationale, to
grant preferential treatm ent on the basis of
the share of residential mortgages in the loan
and investment portfolio than on the legal
type of institution. It is, after all, the avail
ability of mortgage financing that society
wishes to favor and not a particular compet
itive relationship betw een financial institu
tions whose differences are rapidly eroding.
PHASE V
Beyond the elimination or modification of
ceiling differentials, some might envision a
Phase V—the complete disappearance of
interest rate ceilings. All this tinkering with
ceilings has been anathem a to those who
favor unfettered m arkets. Perhaps the logic
of market economics over the longer pull will
prove compelling and Regulation Q will be
dropped, especially as thrifts become more
adaptable to fluctuating interest rates. When it
comes to money and housing, however, peo
ple have a habit of placing less than full trust
in the unregulated m arketplace. Phase V
would appear to be a considerable distance
away.
4
FEDERAL RESERVE BANK OF PHILADELPHIA
Bank Dividend Cuts:
Recent Experience
and the Traditional View
By Howard Keen, Jr. *
Slashing the dividend on common stock
may be considered all right for firms in some
industries, but when it comes to banking, it’s
been a different story. From the 1930s until
very recently, dividend cuts were all but
unthinkable for commercial bankers. The
traditional view was that no banker would
cut dividends unless his bank were in a
severe earnings or liquidity crunch and that
such a move would have a chilling effect on
the bank’s health.
In the past few years, however, several
large banking firms have taken the plunge—
with less than disastrous results. Share prices
have fallen, but deposits have held up sur
prisingly well. All the evidence isn’t in yet,
but it appears that for some banks, under
some circumstances, where other options
seem to be closed off, a dividend cut may be
taken without producing the catastrophic
results that bankers traditionally have feared.
DIVIDENDS IN BANKING
One of the important tasks a banker faces
is that of choosing the right dividend policy
for his bank. How he decides to split his
bank’s income between cash dividends and
retained earnings can affect the cost of his
equity capital and the wealth of his bank’s
shareholders. (In this article, ‘bank’ is used
for both banks and bank holding companies.)
A banker has to resolve two basic issues
about dividends. First, the dividend payout
ratio—the average ratio of cash dividends to
after-tax earnings over the long term —must
be chosen. W hat payout ratio is best will
depend on the earning opportunities of the
* The author, an economist at the Philadelphia Fed,
specializes in banking and business conditions analysis.
Arthur L. Morath, Jr., Assistant Vice President, and
Judith Hanson, Banking Analyst, assisted at various
stages in the preparation of this study.
5
BUSINESS REVIEW
NOVEMBER/DECEMBER 1978
that deviate a lot from previous levels can
impose costs on investors. Also, stable divi
dends might be taken as providing more
information than fluctuating ones both to
current and to prospective investors, i Income
statements may provide incomplete informa
tion about a com pany’s true financial health.
Dividend changes may be viewed as a sup
plementary signal from m anagement of com
ing changes in profitability. To the extent
that more information about a firm makes an
investment in it less risky, its share price will
be higher.
bank and the circumstances of investors (see
DIVIDENDS AND RETAINED EARNINGS).
Second, after choosing the average payout
ratio, bankers still must decide w hat pattern
—stable or unstable—they w ant the level of
their cash dividends to have. Over time, a
bank could pay out an average of 30 cents of
every dollar of earnings, for example, but
quarterly dividends could follow many dif
ferent patterns. There are reasons to believe
that the more stable are these payments, the
more attractive the bank will be to investors
and the more they will pay for a share of its
common stock.
For one thing, dividends may be used by
shareholders as a regular source of funds for
current spending, and dividend payments
■ ^The informational content of dividend announce
ments is discussed by R. Richardson Pettit and Ross
Watts in The Journal of Business46 (1973) and 49 (1976).
DIVIDENDS AND RETAINED EARNINGS
Like their counterparts in other industries, bankers try to build up the value of their firms.
Typically, a firm’s value is measured by the share price of its common stock. And this share price can
be influenced by the payout ratio—the average ratio over time of dividends to after-tax earnings—
which is determined when bankers decide how much of their earnings to pay in cash dividends and
how much to retain.
Whether earnings are paid out in dividends or are retained, they still belong to the shareholders. But
the decision to retain earnings makes a difference to shareholders because it can affect the return they
make on their investments.
Retained earnings are put back to work for shareholders by the bank. If the bank has better earning
opportunities for these funds than are available elsewhere, a higher level of retained earnings will
boost shareholder returns. If the bank’s earning opportunities are not as good, shareholders will do
better with more cash dividends. When earning opportunities are equal, other considerations may
sway investors toward either retained earnings or cash dividends.
Retained earnings provide a relatively inexpensive source of equity capital because they permit
bankers to avoid the flotation costs associated with new issues of common stock. Thus using earnings
instead of other sources of funds can increase bank profitability, share prices, and returns to
investors.
Also, current tax laws encourage investors to favor retained earnings. Dividends, except for the
first hundred dollars, are taxed at a relatively high rate as ordinary income, while increases in share
prices are taxed as capital gains at a lower rate.
Some investors may prefer to take their earnings in cash dividends, however, because dividends are
easier to spend than increases in the value of common stock. While any part of a cash dividend can be
spent, a capital gain can be spent only if shares of stock are sold. The investor who sells shares will
incur transaction costs and may have to sell a share worth many times the amount of money he wants
to spend.
Choosing the most favorable payout ratio is no easy task. Current dividends may well be important
to investors in bank stocks. Yet every dollar paid out in dividends could have been retained. Thus
bankers face a challenge in their efforts to use earnings as equity capital and to do it in such a way that
the price of their banks’ shares won’t suffer.
6
FEDERAL RESERVE BANK OF PHILADELPHIA
dends are deemed to be important to investors
in bank stocks. This may be because investors
tend to count on dividend income as a source
of spending on a regular basis. A dividend
cut, when it represents a break from past
practice, can be disconcerting to current
shareholders and might lead prospective
shareholders to lower their evaluations of
the bank’s stock.
Second, cutting dividends may be inter
preted as a sign that the bank is in much
worse shape than it actually is. According to
one writer, “Forgoing or even reducing a
dividend is generally interpreted as an indi
cation that a bank is in serious financial
difficulty.” And another remarks, “Cutting
dividends has a negative connotation with
investors and reflects a pessimistic view of
the future by m anagem ent.”4 When a bank
has paid steady or increasing dividends in the
past, investors may interpret a dividend cut
more unfavorably than the facts warrant.
Such a m isperception could lead to a dispro
portionate reduction in the bank’s share price
and an unnecessary increase in its cost of
funds.
If a dividend cut is taken as an indication
that the cutting bank has a bleaker future
than it was thought to have, potential inves
tors may offer less for its shares than they did
before. And the reduction in share price that
follows will reduce the wealth of current
shareholders. Part of their wealth consists in
the m arket value of their holdings of stock,
and if the share prices of their bank stocks
fall, that portion of their wealth will be
reduced.
Finally, other suppliers of funds may view
the bank as being riskier. Those suppliers
might include buyers of the bank’s debt
securities and buyers of CDs in denomina
tions that are not covered by deposit insurance.
The upshot of all of this is the possibility of
The aggregate payout ratio of commercial
banks has been trending downward over the
past 15 years. This is not, however, because
of reductions in cash dividends. While divi
dends have not increased as fast as earnings,
they have followed a steady upward path.
Apparently, the arguments in favor of divi
dend stability carry some weight with bankers.
Moreover, one of the argum ents—the one
about the information provided by a change
in dividends—seems to be at the heart of the
traditional view on dividend cuts. The mes
sage that comes through loud and clear from
that view is, “Avoid a dividend cut.”
TRADITIONAL VIEW OF DIVIDEND CUTS
This view was evident in responses by
financial experts to a 1975 survey question
concerning w hat would happen if a major
money center bank were to cut its dividend. 2
The responses had an overwhelming air of
crisis and doom about them. One respondent
noted that the reason for the cut would be of
prime importance, but virtually all seemed to
assume that a cut would occur only under
severe earnings or liquidity pressures.
The traditional view of bank dividend cuts
has perhaps been best summarized by Paul
Nadler: “Dividend cuts are drastic and are
undertaken only when a bank has no alter
native . A bank that cuts its dividend is giving
a signal to the entire financial community
that it has trouble that will not go away soon.
The result is that individual depositors start
shying aw ay from that bank, it finds it hard
to sell certificates of deposit to corporate or
municipal investors, and generally the bank’s
entire posture suffers.”3
Why the Fear of Cuts? Several reasons
have been advanced for the strong fear of
dividend cuts by banks. First, current divi2 “What Would Happen if a Major Money Center
Bank Cut its Dividend?” The Bankers Magazine, Winter
1975, pp. 12-17.
3Paul S. Nadler, “Banks Confronted with Dilemma in
Deciding Dividend Policy,” American Banker, Novem
ber 1, 1977, p. 4.
4Yair E. Orgler and Benjamin Wolkowitz, Bank Cap
ital (New York: Van Nostrand Reinhold Company,
1976), p. 39; George H. Hempel, Bank Capital (Boston:
Bankers Publishing Company, 1976), p. 77.
7
BUSINESS REVIEW
NOVEMBER/DECEMBER 1978
a greatly increased cost of funds to the bank.
And every banker knows what that can mean
to the bottom line of the income statement.
Thus it’s easy to understand the concern
bankers have over the issue of dividend cuts.
FIGURE 1
DISTRIBUTION OF CUTTING BANKS
BY STATE
1 9 7 4 -1 9 7 7
AN UNCOMMON OCCURRENCE:
A HOST OF DIVIDEND CUTS
For about forty years after the Depression,
so far as the records show, bank dividend
cuts were relatively infrequent. The picture
began to change, however, when Central
National Chicago Corporation announced
on December 18, 1974 that it was cutting its
quarterly dividend from 30 cents to 15 cents a
share. 5 And since the Central National
Chicago cut, there has been a good deal of
dividend-cutting activity.
State
1
2
5
2
1
1
4
1
2
3
1
1
1
1
2
California
Connecticut
Florida
Georgia
Illinois
Indiana
Massachusetts
Michigan
New Jersey
New York
North Carolina
Ohio
Oklahoma
Pennsylvania
Tennessee
Profile of the Cuts. For the period 197477, 28 banking institutions cut their quarterly
dividend. Out of the 28 banks, 2 cut in 1974,
10 in 1975, 12 in 1976, and 4 in 1977. These
institutions range in size up to over $5 billion
in assets, and they are located in many areas
of the country, with concentrations in the
Northeast and Southeast (Figure 1).
The cuts ranged in size from 3 cents to 50
cents a share and from 25 percent to 100
percent of the dividend level paid in the
preceding quarter. Thus some of the cuts
were sizable. But even where they w eren’t,
the mere fact that they occurred was rem ark
able (Figure 2).
28 banks
Total -15 states
SOURCE:
Keefe Bankbook 1978.
PROFILE OF DIVIDEND CUTS
In Dollars
In Percent
$ .03-$.50
$.16
$.14
Range of cuts
Average
Median
Performance Before the Cuts. A look at
the financial condition of these banks prior
to the dividend cut shows that dividends
were not cut from a position of strength but
25% - 100%
55%
50%
Size
of Cut
Number
of Banks
Size
of Cut
Number
of Banks
$.01-$.10
.11- .20
.21- .30
.31- .40
.41- .50
®The banks that cut their dividend were identified
from annual data for the period 1973-77 on the 350
largest banking institutions as contained in Keefe Bank
book 1978 (New York: Keefe, Bruyette & Woods, Inc.).
The information from this source was then checked for
stock splits, stock dividends, and declaration dates
using Moody’s Dividend Record (New York: Moody’s
Investors Service, Inc.). The statistics presented in the
text mainly reflect performance of bank holding com
panies rather than of individual banks.
Number of Cutting Banks
11
11
2
3
1
1%- 20%
21 - 40
41 - 60
61 - 80
81 - 100
0
8
13
3
4
SOURCE:
8
Moody’s Dividend Annual.
FEDERAL RESERVE BANK OF PHILADELPHIA
FIGURE 3
PERFORMANCE AT CUTTING BANKS DOWN BEFORE CUTS
Nonperforming
Assets/
Loans and
Net
Earnings/ Other Real Estate Chargeoffs/
Assets
Owned
Loans
Earnings
per
Share
Dividends
per
Share
Payout
Ratio
$2.48
$1.31
52.2%
1973
0%
0.32%
1974
0.43
2.27
0.53
1.76
1.30
63.8
-0.003
7.12
1.10
-0.48
1.18
128.1
1973
)
V
0.58%
1975
CUTTING
0.80
0
0.23
3.19
1.22
37.3
1974
0.79
2.06
0.44
3.39
1.30
38.9
1975
0.67
6.18
0.84
3.00
1.36
49.7
BANKS
MATCHING
BANKS
SOURCE:
I
V
)
Keefe Bankbook 1978.
banks was down less at 0.13 percentage
points. Earnings per share of the cutting
banks fell $2.96 while their dividends per
share fell 13 cents. Over the same period,
earnings were down 19 cents but dividends
rose 14 cents at the matching banks. The
payout ratio for the cutting banks increased
by 76 percentage points while that for the
control group rose 12 percentage points over
this period.
Most of the dividend cuts have been attrib
uted to a combination of financial setbacks
either caused or exacerbated by the economic
recession that began in late 1973. Many of
the losses were related to a depressed real
estate m arket and some were the result of
unprofitable nonbank subsidiaries. As asset
quality deteriorated, chargeoffs increased
and earnings were depressed by the need for
additional provisions for loan losses.
All in all, at least one part of the traditional
view seems to apply to these dividend cuts—
the part which says that banks cut dividends
only under severe earnings conditions. The
other part of that wisdom says that a cut is
took place because of serious earnings and
liquidity problems.6 Information on assets,
earnings, dividends, and stock prices was
collected for 16 of the 28 cutting banks, 7 and
these 16 in turn were paired by size and
geographic location with 16 matching banks
that didn’t cut dividends [Figure 3).
In general, the banks that eventually cut
their dividends were not performing as well
as their counterparts. Their earnings-to-assets ratio had fallen 0.58 percentage points
from 1973 to 1975 while that for the matching
6 For the most part, the analysis of the operating
performance of the cutting banks was done by Judith
Hanson, Banking Analyst, Federal Reserve Bank of
Philadelphia.
7The sample was restricted to the 16 banks for which
information was readily available. How the cutting
banks fare in this kind of comparison can depend upon
which banks are chosen as matching banks. For a bank
to be selected as a matching bank, it had to be of the
same approximate size as the cutting bank, be headquarted in the same approximate geographic location,
and have maintained or increased its quarterly dividend
during the period under study.
9
BUSINESS REVIEW
NOVEMBER/DECEMBER 1978
nearly disastrous. W hat is the evidence on
this from the group of banks under consider
ation?
than $40 thousand are not insured for the
excess, however, and so their owners might
be expected to be scared off by a dividend cut
if anyone would. But even here the cutting
banks don’t appear to have suffered steep
deposit losses.
WERE THE CUTS DISASTROUS?
In a certain sense, w hether the dividend
cuts were disastrous for the cutting banks is
impossible to determine. W hat might be
viewed as a disaster by one banker could be
seen as merely some tough going by another.
What can be done, however, is to consider
deposits, share prices, and operating per
formance at the cutting banks.
While checking the movement in just this
latter category of deposits requires very de
tailed records, we can make a rough pass at
determining the impact of the dividend cuts
by examining movements in total deposits
around the time of the cut. Average total
deposits for the cutting banks and for a group
of matching banks that didn’t cut dividends
are plotted in Figure 4. The matching banks
are comparable in size to the cutting banks
and are located in the same geographic areas.
Around the time of the dividend cuts, deposits
for the matching banks were rising while
those for the cutting banks were falling
slightly. This is generally what the traditional
view says will happen. Nevertheless, tests
on these movements in deposits do not show a
statistically significant decline on average in
the deposits of the cutting banks as compared
Impact on Deposits. If it’s true that a
dividend cut is a “signal” of “trouble that will
not go away soon,” a cut could make depos
itors begin to worry about the safety of their
deposits. Fortunately, most depositors have
little to be concerned about in this regard.
Bank accounts are insured for up to $40
thousand by the Federal Deposit Insurance
Corporation; so as long as the cutting bank
carries FDIC insurance, there is little need
for account holders with $40 thousand or less
in each account to worry. Accounts of more
FIGURE 4
AVERAGE DEPOSITS DECLINE SLIGHTLY
AROUND TIME OF DIVIDEND CUT*
Millions of Dollars
‘The quarter of the cut is designated zero. The numbers of quarters preceding the cut and following the cut are
given by {-) and (+) respectively. Average deposits are average total deposits as of either June 30 or December 31.
---------------------
SOURCE:
;•
v
Polk’s World Bank Directory.
10
FEDERAL RESERVE BANK OF PHILADELPHIA
dividend cut indicates to investors that profit
prospects are declining, their evaluation of
the bank could become less favorable and the
price of the bank’s stock could drop after the
announcem ent of the dividend cut.
Average stock prices for the cutting group
and the matching group are shown in Figure
5. The average share price for the cutting
banks falls in the quarter of the cut and
shows little recovery in the five quarters that
to the matching banks.8 If the cutting banks
suffered losses in any deposit category, these
losses apparently were not severe enough to
affect their overall deposit positions relative
to those of the matching banks.
Impact on Stock Prices. The share price
of a bank can be taken as an indication of
investors’ assessments of that bank. If the
^Statistical tests were conducted for total deposits,
share prices, and three measures of operating perform
ance. In every case, the value for each cutting bank
was divided by the corresponding value of its matching
bank, and the change in this ratio from one period to the
next was computed. The one-tail t-test then was used to
test the hypothesis that the average change in these
ratios from one period to the next was equal to zero. The
tests were conducted for three consecutive periods
beginning with the one immediately preceding the
dividend cut. Data for total deposits were taken from
Polk’s World Bank Directory [Nashville, Tenn.: R. L.
Polk & Co.), various issues, and are as of either June 30
or December 31. Share prices are the bid prices as
published in the Commercial and Financial Chronicle
and are as of the last week in either March, June,
September, or December. The three measures of oper
ating performance are earnings to assets, nonperforming
assets to loans and other real estate owned, and earnings
per share. Data for these are as of December 31 and can
be found in Keefe Bankbook 1978. The tests were
conducted using the 95-percent confidence level.
The impact of a dividend cut might be reflected also
by measures that haven’t been examined in the course of
this study. These include holdings of Federal funds
(excess reserves that banks lend to one another for short
periods) and rates paid for borrowed funds.
In the case of share prices and deposits, it was
assumed that no new information about the bank
became available to investors or depositors between the
dividend cut announcement and the next share price or
deposit observation. It was assumed also that any loss of
deposits was the result of actions initiated by depositors
and not the result of a bank decision to reduce the level
of its deposit liabilities.
FIGURE 5
AVERAGE SHARE PRICES FALL
AROUND TIME OF DIVIDEND CUT*
♦ The quarter of the cut is designated zero. The numbers of quarters preceding the cut and following the cut are
given by (-) and (+) respectively. Share prices are averages of prices as of the last Friday in the calendar quarter.
SOURCE:
Commercial and Financial Chronicle.
11
BUSINESS REVIEW
NOVEMBER/DECEMBER 1978
follow. For the matching group, the average
share price rises slightly at first and then
more rapidly in subsequent quarters.
Statistical tests show that in the quarters
surrounding the cut, the share prices of the
cutting banks did not fall significantly com
pared to those of the m atching banks. In the
quarter of the cut, however, the share prices
of the cutting banks dropped an average of 21
percent while prices for the matching banks
rose by an average of three percent. 9
sures of operating performance can provide
an idea of how the cutting banks have fared
since the time of the dividend cut.
On the whole, cutting banks have made
significant strides toward improving their
operations (Figure 6). Nonperforming assets
dropped from 7.1 percent of total assets in
1975 to 5.3 percent in 1977, and earnings per
share increased from an average loss of 48
cents to a gain of $1.11 in two years. As
might be expected, the average dividend per
share at the cutting banks was down to 48
cents from $1.18 over the same two years. In
addition, the cut in dividends along with the
improvement in earnings perm itted a drop in
the payout ratio from an unsustainable 128
percent to a much more manageable 40 per
cent. All in all, it appears that the cutting
banks made significant inroads into the con
ditions that led them to cut their dividends.
They not only survived the dividend cuts but
also made progress in getting their financial
houses back in order.
Operating Performance After the Cut.
The impact of a dividend cut on a bank’s
ability to attract equity capital and deposit
funds at a reasonable cost obviously has to
make a difference to bank mangement. Per
haps the bottom line, however, is how it
affects operating performance. While this is
not easy to determine, a look at some mea^Depositors may view the dividend cut favorably
since it provides them with additional protection against
future losses. Investors may view it unfavorably, how
ever, since it reduces current income and occurs at a
time when the bank's earning opportunities don’t prom
ise a higher return later on.
TOWARD A REASSESSMENT
How does the traditional view stack up in
FIGURE 6
OPERATING PERFORMANCE IMPROVES AFTER CUTS
Nonperforming
Assets/
Loans and
Net
Earnings/ Other Real Estate Chargeoffs/
Assets
Owned
Loans
1975
-0.003%
7.12%
1.10%
1976
-0.02
7.11
1977
0.22
1975
Earnings
per
Share
Dividends
per
Share
Payout
Ratio
$ -0.48
$ 1.18
128.1%
1.55
-0.37
0.56
99.5
5.28
0.91
1.11
0.48
40.0
0.67
6.18
0.84
3.00
1.36
49.7
1976
0.61
4.86
0.78
2.90
1.39
52.2
1977
0.64
3.56
0.49
3.31
1.44
44.6
CUTTING
>
BANKS
)
MATCHING
|
BANKS
SOURCE:
Keefe Bankbook 1978.
12
FEDERAL RESERVE BANK OF PHILADELPHIA
tion that caused them to lower their assess
ments of the banks’prospects. They might be
reacting to a drop in earnings, announce
ments by management, or public forecasts
by bank stock analysts. W ithout detailed
systematic information on these other possi
ble sources of bad news, there’s no way to tell
how much of a negative impact, if any, is the
result of the dividend cut.
But while the verdict isn’t in on the precise
impact of dividend cutting, a look at the
performance of cutting banks shows that
whatever that impact was, it has not pre
vented these banks from making steady pro
gress in getting their financial houses back in
order. In short, while the recent experience
with bank dividend cuts suggests that the
traditional view still has some truth to it, the
part of it that says a dividend cut will be the
deathknell of a bank should be reexamined.
For banks that find themselves in the same
boat as the cutting banks, a dividend cut may
be a prudent step toward improving long-run
health.
light of these recent dividend cuts by large
bank holding companies? First of all, the part
of the view that says dividends are cut only
when a bank has no alternative does seem to
hold in these cases. It appears that dividends
were cut reluctantly and only after m ain
taining them became extremely difficult.
The cuts did not take place because bankers
spurned the conventional wisdom. Secondly,
the part that says a dividend cut will have
dire consequences doesn’t fit as closely, at
least not in its extreme versions. Investors
appear to have lowered their assessments of
the banks, since, on average, the share prices
of the cutting banks fell significantly com
pared to those of the matching banks. In
terms of total deposits, however, there is no
evidence that the cutting banks suffered in
relation to the matching banks around the
time of the dividend cut.
With the traditional view in mind, it would
be tempting to attribute the drop in stock
prices to the fact that the dividend was cut.
But to do this would be jumping the gun.
Investors may have received other inform a
SUGGESTED READINGS
For a theoretical treatment of dividend policy, see James C. Van Horne, Financial Management and
Policy, 4th ed. (Englewood Cliffs: Prentice-Hall, Inc., 1977], chapters 11 and 12, and Lawrence D.
Schall and Charles W. Haley, Introduction to Financial Management (New York: McGraw-Hill Book
Company, 1977), chapters 9 and 10. The application of this theory to banking is considered in George
H. Hempel, Bank Capital (Boston: Bankers Publishing Company, 1976), and Yair E. Orgler and
Benjamin Wolkowitz, Bank Capital (New York: Van Nostrand Reinhold Company, 1976).
For empirical tests of what determines bank dividend payments, see Manak C. Gupta and David A.
Walker, “Dividend Disbursal Practices in Commercial Banking,” Journal of Financial and Quantitative
Analysis (September 1975), pp. 515-529. The role of holding company affiliation on these practices is
examined in Lucille S. Mayne, "Bank Dividend Policy and Holding Company Affiliation,” Federal
Deposit Insurance Corporation, Working Paper No. 78-2.
13
From th e
Philadelphia
FED ...
ft5
'
■
1 ■t ■
.
or
W ha t M ay
Happen W hen
You Pay O ff a
Loan Early
FEDERAL RESERVE BANK
— mOF P H ILA D E LP H IA ^
Copies of this pam phlet, which explains how to figure the interest when you
pay off a loan early, are available without charge from the Department of
Consumer Affairs, Federal Reserve Bank of Philadelphia, P. O. Box 66,
Philadelphia, Pennsylvania 19105.
FEDERAL RESERVE BANK OF PHILADELPHIA
Upward Biases
in Government Spending?
By Anthony M. Rufolo*
A recent cartoon showed a fleeing govern
ment employee shouting: “Run! Jarvis is
coming to tow n!” Somehow, the notion has
gotten around that Proposition 13 erupted
quite unexpectedly. But it may be just one
m anifestation of a growing awareness and
concern about the level of government spend
ing.
Since spending is closely related to services,
proposals to cap expenditures represent
opportunities for taxpayers to focus on the
tradeoff of spending against services. Debate
on these proposals, however, rarely takes
the form of a cool discussion of tradeoffs.
Those who speak most ardently for the
disadvantaged want more services and deem-
phasize the tax burden. Those who speak
most ardently for the taxpayer want lower
taxes and deemphasize the importance of
services. Although both sides seem reluctant
to admit it, issues of equity and efficiency in
the volume and allocation of government
spending underlie the exchanges. W hat hard
evidence exists for helping to make the
tradeoff choice?
The issues that bring town meeting partic
ipants to their feet are equity issues—concern
about abandoned housing, concern about the
tax burden of the middle class, and concern
about welfare, to name a few. These concerns
are more likely to be resolved through the
dialogue of democracy than through a mar
shalling of hard evidence.
But the efficiency issues underlying de
bates about such matters as housing subsidies,
farm price supports, and aid to education, for
example, can be examined more precisely.
Government spending decisions flow from a
*The author, who joined the Philadelphia Fed’s
Department of Research in 1974, received his Ph.D.
from the University of California at Los Angeles. He
specializes in urban economics, microeconomics, and
public finance.
15
BUSINESS REVIEW
NOVEMBER/DECEMBER 1978
framework of calculations of program costs
and benefits. While the procedures under
lying this fram ework are sound in principle,
implementing them produces some difficul
ties, and these difficulties may result in a
tendency toward overspending by govern
ment.
World W ar II, fell off to around 20 percent in
the postw ar period, and than grew steadily to
their present range of 30-35 percent.
The percentage dipped in 1976 and 1977,
probably reflecting the relatively rapid growth
in GNP and reduction in social welfare
programs that occur as the economy comes
out of a recession. But except for the drop
following World W ar II, there has been no
five-year period since 1930 in which gov
ernment expenditures have not shown growth
both in absolute terms and as a percentage of
GNP.
Of all governments in the United States,
the Federal government has been the biggest
spender and has had the fastest rate of
growth since 1949 (see GOVERNMENT
SPENDS A GROWING SHARE. . .). Much
of this growth has been in the form of
WHAT DOES GOVERNMENT SPEND?
It’s estimated that government expendi
tures in 1977 totaled $621.2 billion—an in
crease from only $11.1 billion in 1930. While
inflation and the growth of the economy
explain much of this jump in dollar outlays,
government expenditures have been growing
not only in absolute dollars but also as a
percentage of GNP. From a relatively low
level of slightly over 12 percent in 1930, they
rose to well over 40 percent of GNP during
GOVERNMENT SPENDS A GROWING SHARE OF GNP
WITH MOST OF THE GROWTH IN STATE AND LOCAL PURCHASES
AND FEDERAL TRANSFER PAYMENTS
(Dollar figures are billions)
1949
1959
1970
1975
1976
1977*
State and Local Government
Purchases of Goods and Services
(percentage of GNP)
$18
(7.0%)
43.7
(9.0)
123.2
(12.5)
215.6
(14.1)
231.2
(13.5)
249.5
(13.2)
Federal Government
Purchases of Goods and Services
(percentage of GNP)
19.3
(7.5)
54.7
(11.2)
97.0
(9.9)
123.3
(8.1)
130.1
(7.6)
145.4
(7.7)
State and Local Government
Transfer Payments to Persons
(percentage of GNP)
3.0
(1.2)
5.1
(1.0)
14.6
(1.5)
23.8
(1.6)
25.9
(1.5)
28.0
(1.5)
Federal Government
Transfer Payments to Persons
(percentage of GNP)
8.1
(3.1)
19.8
(4.1)
55.0
(5.6)
146.1
(9.6)
158.8
(9.3)
169.8
(9.0)
Federal Grants-in-aid
to State and Local Governments
(percentage of GNP)
2.1
(0.4)
6.2
(1.3)
22.6
(2.3)
54.6
(3.6)
61.0
(3.6)
67.6
(3.6)
486.5
982.4
GNP
$ 258.0
1,528.8
1,706.5
1,890.4
* Preliminary.
SOURCES: Facts and Figures on Government Finance 19th ed., Tax Foundation, Inc., N.Y., Tables 28 (p. 43), 60
(p.78), and 112 (p.136) for figures before 1975, and United States Department of Commerce, Bureau of
Economic Analysis for 1975-77.
16
FEDERAL RESERVE BANK OF PHILADELPHIA
THE FORMS
OF GOVERNMENT SPENDING
Government spending usually is thought
of in the very simplest terms— direct procure
ment, direct expenditures to run operations,
and direct outlays to designated citizens. We
think of government as the buyer of pencils,
the employer of recordkeepers, and the sup
plier of prekindergarten education to disad
vantaged children. But different types of
expenditures can have very different ef
fects.
If government spending finances the pro
duction of desirable goods and services which
would not be produced otherw ise—sending a
man to the moon, perhaps—allocation of re
sources may reflect citizens’ preferences more
fully than private-sector spending would. If
dollars are dispensed in the form of matching
funds or other financial incentives to get
transfer payments to individuals (such as
Social Security) and to other governments
(revenue sharing, for example) which totaled
about $237 billion in 1977. State and local
governments, with the help of Federal trans
fer payments, increased their direct pur
chases of goods and services to almost $250
billion in 1977.
These numbers can be put into perspective
by considering that over the last year, Federal,
state, and local governments in the U.S.
spent about $8,400 for each household in the
country. Households were not taxed this
amount directly, though they did finance it
indirectly (see DO YOU PAY MORE TAXES
THAN YOU REALIZE?). And expenditures
seem likely to continue growing. The full
impact of these expenditures, however, is
not entirely visible even from these sizable
dollar numbers.
DO YOU PAY MORE TAXES THAN YOU REALIZE?
When people hear that governments spent $8,400 for each household, they probably feel that they
must be coming out ahead. After all, not many families appear to pay over $8,000 a year in taxes. But
the fact is that most people pay far more in taxes than they realize. Certain taxes are more visible than
others—taxes on income and retail sales, for example. Not only these, however, but all taxes
ultimately are paid by individuals.
Take, for example, the corporate income tax. This tax, though not always in any obvious way,
comes from customers through higher prices, from employees through lower wages, or from
stockholders through a reduced return on investment.*
The incidence of a tax—how its burden is distributed—will fall more heavily on some than on
others, depending on what kind of tax it is. But, in the end, the tax will be paid by some set of people.
Thus, to get a better estimate of his total tax burden, an individual would have to figure out how much
higher prices are because of taxes, how much lower his wages are, and what additional return he
would get from his investments.
The tax bills which he receives are a misleading guide to each person’s contribution to government
spending, however, not only because some taxes aren’t visible but also because government can
finance its spending by borrowing as well as by taxing. Government spending, not current taxation,
determines what percentage of the nation’s resources eventually goes to the public sector. Thus
government collects more in taxes than most people realize, and expenditures are greater than taxes
because of debt financing.
’ Public Service Electric and Gas Company of New Jersey recently circulated a notice to its customers pointing
out that 17 percent of its revenue went to paying taxes. Since Public Service is a regulated utility, it seems
reasonable that prices are at least 17-percent higher because of the taxes. For other companies, the people who pay
the tax seldom can be identified so readily.
17
NOVEMBER/DECEMBER 1978
BUSINESS REVIEW
designed at least partially to curb consump
tion of certain goods, such as cigarettes and
liquor. And tax provisions designed to cut
energy consumption have been proposed.
For some items taxes are designed to act as
prices for government-provided goods and
services: the gasoline tax and, to some extent,
the Social Security tax are examples. And
taxes are used also in attem pts to stabilize the
economy.
The role of government expenditures, then,
is larger than it first appears. Besides the
direct and obvious outlays, there are large
and less obvious impacts through the alter
ations that expenditures and revenue raising
make on our economy. It is little wonder that
the size of government expenditures has
become a serious issue for the nation and
that the bases on which the levels are deter
mined has come in for urgent questioning
(see THE AIMS OF GOVERNMENT
SPENDING).
someone else to do something desirable,
society as a whole may benefit. The Federal
government, for example, often uses finan
cial incentives to shape the behavior of local
governments. And spending can bring about
a desired change in the distribution of income
to individuals by providing them with cash
grants or with goods and services such as
medical care. (From one point of view, gov
ernment provision of any item equally to all
is a change in the distribution of income
because, in a free m arket, people don’t all
buy the same things in the same amounts.)
Further, tax forgiveness can act as a sub
stitute for government spending. Tax deduc
tions, credits, preferences, or loopholes can
alter private-sector behavior by reducing tax
payments. Selective tax reduction has the
same effect as collecting taxes and then
offering subsidies, which vary with the recip
ients’ tax brackets, for engaging in certain
activities. It is estimated that these selective
tax provisions are equivalent to additional
government spending of tens of billions of
dollars per year. 1
Finally, taxes are used not only to finance
government expenditures but also to promote
other goals. Redistributing income is one
added aim of Federal taxation: the personal
income tax increases in rate with higher
incomes, and the intent of the corporate
income tax appears to be to tax shareholders,
who are regarded as the relatively wealthy.
Raising the price of underpriced goods or
undesirable items is another aim: in practice,
few taxes appear to have been enacted to
offset items not captured through the market,
such as pollution, but some taxes have been *
DECIDING HOW MUCH TO SPEND
M any noneconomic considerations enter
into government decisionmaking on how
much to spend. Political scientists recognize
that the squeaky wheel may have to be oiled;
elected officials may w ant to be reelected,
and getting reelected may require support for
government expenditures that are not justi
fiable on economic grounds. But an accurate
analysis of economic efficiency can be of
great assistance to decisionmakers. Most
economists agree that a thoughtful applica
tion of the cost-benefit fram ework can help
to identify efficient program spending levels.
Does Government Spend Enough? State
and local governments, quite naturally, focus
on the benefits that expenditures will bring
to their own constituents. This behavior
suggests an economic argument for the posi
tion that government spends too little.
While the local taxing jurisdiction often
can tax only its own residents, nonresidents
also may be affected by the governm ent’s
actions. Community A may decide to spend
*For details, see Special Analyses, Budget of the
United States Government, Fiscal Year 1979, U.S.
Government Printing Office, Washington, D.C., 1978,
pp. 148-174.
Government influence over the economy is not limited
to spending. Other kinds of government actions, such as
changes in the minimum wage or in certain loan guaran
tee provisions, also can have an impact, even though
they are not connected directly with current budget
levels.
18
FEDERAL RESERVE BANK OF PHILADELPHIA
THE AIMS OF GOVERNMENT SPENDING
The U. S. and other predominantly capitalist nations rely heavily on the free market system to
direct resources toward their most productive use, to produce the goods that people want, and to
allocate much of the final product. But unhindered markets are not always the best instruments for
achieving these economic goals. And so most agree that government spending should be used to
exercise some influence over the private economy. Among the most common aims of government
spending are redistribution of income, correction of imperfect pricing, provision of goods and
services that private markets can’t provide, and stabilization of the economy when it runs off course.
Income Redistribution. The market, though it allocates productive resources efficiently, may
not satisfy people’s preferences for greater economic equality.
The market’s efficiency shows up in rewarding people for using their labor and their other resources
where they will be most productive. But the productiveness of resources, and so the price they bring,
will vary with circumstances. Many people believe that something should be done to counterbalance
the effects of resource ownership and unforeseen circumstances on income, and so they have
supported government programs of unemployment insurance and educational assistance.*
Markets With Deceptive Signals. In a market economy, prices tell consumers the value of the
resources used in producing goods and services, and they tell producers how highly consumers value
additional units of goods and services. Thus prices make it possible for a decentralized economy to
allocate resources efficiently. But not all prices provide reliable information.
Some prices don’t convey the full cost of production—as, for example, when a firm pollutes water
as it manufactures consumer goods and then fails to include the cost of cleaning that water up when it
prices its products. Other prices may overstate the real cost of production because the producing firm
is a monopolist and doesn’t have to worry about losing customers to competing firms. Further, prices
may not reflect the total value of certain goods and services to consumers because people other than
the purchasers place value on these outputs.
When prices don’t carry correct information, then government may be able to improve the
allocation of resources by regulating the market directly or through taxes and subsidies.
Goods and Services Without Markets. Not all goods and services can be sold in a private
market. The only feasible choice for some of them, such as national defense, is to have government
provide them and finance them through taxes. In even more cases, government provision, though not
the only available method, may be the most efficient. Thus governments construct and maintain most
roads and parks.
Economic Stabilization. Many economists believe that leaving the market to run by itself may
not keep the economy fully employed. And so, when demand and supply conditions at prevailing
prices make for an underuse or overuse of resources, they counsel government intervention.
In principle, stabilization policy should have no permanent effect on the size of government
spending. But, in fact, programs initiated or expanded to increase spending during an economic
slump often are not cut back when the economy approaches full employment. Thus stabilization
efforts may tend to ratchet government spending upward.
‘ For more information on income distribution see Timothy Hannan, "Measuring Income Distribution in the
United States,” Business Review, Federal Reserve Bank of Philadelphia, March/April 1978, pp. 3-11.
very little, for example, on street repairs and
traffic control, and this decision may create
traffic tie-ups in Community B by causing
some people to change their travel routes.
The residents of B would benefit if A were to
spend more on traffic control, but this con
sideration may not enter into the decision
making in A.
Or Should It Spend Less? On the other
side, there are a number of economic efficien
cy arguments which suggest that government
19
NOVEMBER/DECEMBER 1978
BUSINESS REVIEW
The concept is simple, but the implemen
tation is difficult. M any costs and benefits
resist measurement, and many are not even
perceived. W hat is the precise benefit of
building one more missile, for example, or of
training one more unemployed person? What
are the precise costs of eliminating a recre
ation area to make way for a reservoir? These
cost-benefit questions, which are hard enough
to answer for the present or the near term,
become even harder as the time horizon
being considered recedes into the future.
Attempts often are made to answ er these
questions in actual evaluations of govern
ment programs. But it is hard to trace out
program impacts. The fact that the private
market is not doing it, and government is,
has certain costs associated with it. These
added costs are not included in the standard
cost-benefit calculation although they tend
to bias the analysis toward overstating the
benefits and understating the costs of govern
ment programs. 2
tends to spend too much. Perhaps the most
important of these argum ents is that special
interest groups have a strong incentive to get
programs passed that favor themselves while
taxpayers at large do not have an equally
strong incentive to fight such programs. The
benefit to the special interest groups can be
large for each of a small num ber of members:
they have a strong incentive to lobby. But a
very large number of taxpayers will be split
ting the bill, and so the tax savings to any of
them for opposing the program are small. On
net, then, projects sponsored by special in
terests have an unduly high probability of
being enacted.
A recent example of such a situation can
be found in the farm aid program. Federal aid
to farmers in fiscal 1978 is expected to
exceed $10 billion. And although consumer
food prices already are higher than they
would be in the absence of government
programs, it’s expected that both direct Fed
eral aid to farmers and food prices will
continue to rise. Farmers clearly want pro
tection from price fluctuations, and they
work effectively to obtain it despite the fact
that taxpayers at large would prefer lower
food prices and lower taxes. And farmers are
not alone in receiving special treatm ent for
their products. Thus government may be
spending too much on programs that mainly
benefit certain relatively small groups.
BIASES TOWARD HIGHER SPENDING
Dollar figures can be estimated for many
costs and benefits, including many of the
nonmarket ones. Much work has been done,
for example, on valuing a hum an life. And
adjustments can be made for the differences
in timing of costs and benefits. But plugging
these figures into the cost-benefit calculation
usually won’t give a complete picture of the
effect government programs have on people
and on the economy at large.
How To Decide. Economists have pro
posed a conceptually simple test to help
guide them in identifying efficient levels of
government spending. The efficiency of any
government program is to be evaluated by
examining its costs and its benefits and
calculating a net value. If benefits exceed
costs, then the program is presumed desirable
and may be a candidate for expansion. But if
benefits are smaller than costs, then the
program probably should be cut back or
eliminated. And the appropriate size of the
program can be judged by considering wheth
er a small increase or decrease in expendi
tures will lead to a comm ensurate change in
benefits.
Current Tax Dollars Understate Program
Costs. Tax revenue is the most obvious
source of information on the cost of govern2Even when cost-benefit analyses of government
programs avoid these difficulties, the question of pro
duction efficiency remains an open one. Production
costs usually are taken for granted in cost-benefit
analyses with no attention to whether they are higher
than they should be. The acceptance of historical
production costs doesn’t tend to make these costs look
any smaller (or larger) than they are, but it may lead
people to put up with costs that are larger than they have
to be.
20
FEDERAL RESERVE BANK OF PHILADELPHIA
(after taxes) to pay the painter; so it will save
Smith more than an hour’s wage to do it
himself, even though it would have been
more efficient to have the painter in. Thus
the distortion caused by the tax leads to an
inefficient allocation of resources: Mr. Smith
wastes two hours of productive time. This
effect is multiplied many times over in the
U.S. economy but would not be picked up in
even a careful cost-benefit calculation.
Besides the dislocation cost, there is the
cost of compliance with government regula
tions, and this cost usually isn’t included in
cost-benefit analyses of government pro
grams (see DOES GOVERNMENT REGU
LATE TOO MUCH?). Most individuals and
firms appear to feel the cost of compliance
most keenly in the time they spend on record
keeping for tax purposes. Indeed, some cor-
ment programs. But just adding up the dollars
spent will understate the true cost of direct
expenditures. Government creates distortions
in the economy through its taxing activities.
M any programs themselves generate com
pliance costs. And government sometimes
can create m onetary liabilities which don’t
show up in current accounts but will have to
be paid in the future.
How Do Taxes Distort? Take the case of
Mr. Smith, who wants some painting done.
Smith and his painter both earn $6 per hour
and pay a quarter of their income in taxes. If
Smith elects to do the job himself, it will take
him twelve hours, while the painter can do it
in ten. W ithout the tax, it would be cheaper
to have the painter do it; Smith would have to
work more than thirteen hours to earn enough
DOES GOVERNMENT REGULATE TOO MUCH?
Government can change the allocation of resources by regulating as well as by taxing and spending.
In fact, government has a pervasive influence on the economy because it makes the legal rules of the
economic game. Generally, this just takes the form of providing the legal framework in which private
participants act, but it can extend up to very strong controls on some industries.
In direct regulation of utilities, for example, rates are set and some production decisions may be
made by government agents to avoid the high prices and low output that a monopoly might choose.
Regulations about pollution, building codes, and worker safety also influence how resources are
allocated in the private sector with a relatively small amount of government spending. Regulation can
have an impact also on the distribution of income. It appears that some airlines and railroads are
allowed to charge prices greatly above costs on some routes so that they can run other routes where
prices are below costs and still make a profit. This amounts to a redistribution from some customers to
others although it doesn't show up in figures on government taxation and spending.
Regulation may be an effective tool for achieving government’s aims, and it often is favored
because its direct costs are relatively low. But regulation also generates some hidden costs which
must be added to the actual expenditures when evaluating the results. In trying to achieve the
government’s goals, regulators may create important economic distortions. One such distortion
comes from setting prices without sufficient regard for the appropriate measure of cost. It has been
argued, for example, that the rates railroads are required to charge put them at a disadvantage to
trucks for a number of commodities in which they are the more efficient carrier. Such price regulation
is estimated to inflate national freight costs by $1 billion per year or even more.* In other words, if
regulators were to set prices so that they more closely reflected the cost of providing services,
railroads would be expected to win back some types of business now going to higher cost trucks. And
the nation’s freight bill whould be lower by at least $1 billion per year. Thus the costs of regulation are
often much higher than they appear to be.
*See Robert W. Harberson, “Toward Better Resource Allocation in Transport,” Journal of Law and Economics
12 (1969], pp. 321-338.
21
NOVEMBER/DECEMBER 1978
BUSINESS REVIEW
Is the housing worth $200 to them ? Presum
ably not, since, if it were, they would have
rented the space already. So far as the family
is concerned, they would appear to be satis
fied better by a cash grant of $200 which they
could use to increase their consumption of
goods other than housing. In fact, they might
rather have a cash grant of, say, $150 than a
housing unit worth $50 more. 3
But there are many hard-to-document links
between programs and effects on society
that are not reflected in the dollar numbers.
And this may lead to an understatement of
benefits. Headstart and Follow Through
programs, for example, may raise the skills
of the participants, and this improvement
might be reflected with some accuracy in the
calculations of benefits. But it is possible
that other, long-run consequences of better
education—perhaps lower crime rates and
better health—may not be included in the
calculation.
Returning to the housing example, gov
ernment may see benefits in housing of a
certain grade that the recipients of that housing
don’t see. Continued use of substandard
units, for example, might pose fire or health
hazards to residents of other units nearby,
and the cost of offsetting these hazards might
exceed the cost of relocating the occupants
of the substandard units. Since the total
benefit of a housing program may exceed the
dollar value of the units it provides, using the
dollar value of those units as if it represented
the total benefit provided may understate the
benefits. Thus getting accurate benefit esti
mates for government programs is a slippery
business at best.
porations and other institutions maintain
whole staffs of tax accountants and attorneys.
But the IRS is not the only source of compli
ance costs; regulations issued by other agen
cies at all levels of government create addi
tional costs. The Commission on Federal
Paperwork recently estimated that the cost
of paperwork required by the Federal gov
ernment alone may exceed $100 billion per
year and that at least $10 billion of this is
unnecessary. Clearly some administrative
costs are required in the operation of govern
ment, but ignoring the private and public
costs of compliance in determining the de
sirability of government action understates
the total cost of government.
Further, the tax bite is an inadequate guide
to government program costs because gov
ernment can spend m oney it hasn’t collected.
Pension programs offer the main examples
of this hidden expenditure. When govern
ments make pension commitments without
collecting enough funds to cover them, they
are in effect borrowing money, because those
funds, along with the interest they would
have earned, will have to be raised when
current workers retire.
In short, because of the dislocation and
compliance costs that taxes impose on the
economy, and because government finances
some of its programs with unfunded liabilities
rather than revenue (current taxes], the true
total program costs are not fully represented
by present-year dollar expenditures.
Dollar Value May Be a Poor Measure of
Benefits. Likewise, the true total benefits of
government programs may not be measured
correctly by the dollar value of the goods and
services they provide. Starting the evaluation
of benefits from the dollar value of inputs
can lead to an overstatement of benefits. The
overstatement may occur because the direct
recipients of the benefits may not value them
at their cost.
Suppose, for example, that government
provides a family with housing that the
family could have rented for $200 per month.
On Balance, a Bias. There are overstate
ments and understatem ents in the estimates
of the benefits from government programs.
But the government program funding process
does appear to suffer from a tendency to
^For a more detailed analysis see Armen A. Alchian
and William R. Allen, University Economics: Elements
of Inquiry, 3rd edition (Belmont: Wadsworth Publishing
Company, Inc., 1972), pp. 148-152.
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understate the costs of compliance and dis
location. The net effect is to bias the calcula
tion—to make the net costs appear to be
lower than they are. Thus government may
be led to authorize some expenditures which
would be recognized as undesirable if the full
costs were tracked through.
The information that the competitive m ar
ket provides about consumer preferences
and costs of production usually is not avail
able to government enterprises. And when
that information is available, the discipline
of the m arketplace is not available to ensure
that it is acted upon. As a result, even wellintentioned government personnel may be
providing goods and services which are not
w orth their cost or which are produced
inefficiently.
grams can provide a useful framework for
some of the information needed for an effi
cient allocation of resources both between
the public and private sectors and within the
public sector. Already it appears to have led
to a number of improvements in the way
government expenditure decisions are made.
Now, for example, the Congressional Budget
Office provides members of Congress with
estimates of the costs of proposed Federal
legislation for the next five years; and zerobase budgeting and sunset legislation make it
easier for legislatures to reevaluate the costs
and benefits of programs periodically.
Cost-benefit analysis cannot provide a
framework for resolving the equity issues
underlying the debates on government pro
grams. Equity concerns, however, should
enter the decision process after there is a
clear understanding of the efficiency consid
erations. Such efficiency evaluations would
be considerably sharpened by greater atten
tion to the deeper costs and benefits.
If this were done, it almost certainly would
be concluded that while government action
is desirable in some areas, there are other
areas where less government activity is called
for. The benefits of government spending are
significant, but there appear to be tendencies
to understate its costs. While it is clear that
the criterion of economic efficiency is not
appropriate by itself for judging government
actions, it provides an important discipline
for voters and policymakers as they strive to
make reasoned judgments on appropriate
levels of government spending.
WHAT CAN BE DONE?
The movement to place limits on govern
ment spending appears to be growing. Even
before Proposition 13, Congress began to set
itself overall spending ceilings to use as it
considered individual items of legislation
each year. And there are a number of state
and local governments which have statutory
or constitutional limits on government spend
ing. This approach does not guarantee that
government is left with the appropriate
amount of money to spend nor does it take
into account the differences in the size of the
cost errors in different programs; but it can
restrict the tendency of governments to spend
too much money.
Cost-benefit analysis of government pro
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