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The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the
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Proposition 13 and
Financial Markets
I.
Introd uctio n and Sum m ary
5
II.
Proposition 13— Genesis and Consequences
W illiam H. Oakland
7
... The Jarvis-G ann Initiative achieved several of its objectives, but
its initial im pact on p u b lic -e x p e n d itu re grow th was modest.
III. The Effect of P roposition 13
on C alifornia M unicipal Debt
Jack H. Beebe
25
... The Initiative affected p a rticu la r kinds of m unicipal debt in vastly
d iffe re n t ways because of the sp e cific w o rd in g of the am endm ent.
IV. C om petition Between the C om m ercial Paper
Market and C om m ercial Banks
John P. Jud d
... A m ajor portio n of large co rp o ra te fina n cin g has shifted from
large banks to the co m m e rcia l-p a p er m arket in the past decade.
E ditorial com m ittee fo r th is issue:
Charles P igott, M ichael Bazdarich, Kenneth Froewiss
3
39
"Taxes," said Justice Holmes, "are the price
we pay for civilized society." If that be true,
Westerners were in a downright uncivilized
mood in 1978, because voters in five Western
states overwhelmingly adopted tax-or spendinglimitation measures during the year. Voters in
only one state (Oregon) rejected such a measure
where it appeared on the ballot, and that may
have been simply because two competing ballot
measures cancelled each other out.
The most widely publicized of these measures
was California's Proposition 13-the JarvisGann Initiative-which was designed to reduce
local property taxes 57 percent and to curb
future tax increases of either the state or local
variety. This $7-billion tax reduction amounted
to almost one-fifth of the total revenues raised by
all levels of California governments. Yet despite
widespread campaign rhetoric, Proposition 13
did not bring about a collapse of California
public services or public finance-nor did it
usher in the millenium. Nonetheless, the measure
did have important economic and financial consequences, which are evaluated in two articles in
this issue of the Review. The third article analyzes an important financial development of the
past decade-the rapid growth of the commercial-paper market.
William H. Oakland cautions that the circumstances surrounding Proposition 13 were almost
unique to California. A major contributing factor to its success was a high and growing statelocal tax burden during a period when similar
burdens were levelling off in other states. A
second factor was a substantial shift in the
distribution of property-tax burdens towards
home-owners, at a time when inflation already
was causing budgetary problems for many
households. And a third factor was the emergence of a massive California state-government
surplus in the period preceding the election.
Oakland notes that Proposition 13 achieved
two of its three major objectives-property-tax
reduction and state-surplus liquidation. However, its initial impact on public-expenditure
growth was rather modest, largely because the
state government provided more than $4 billion
in direct assistance to local governments out of
its surplus funds. "In its first year, it required
only a 2.8 percent reduction in the average level
of public services; in the near future, barring a
major recession, it may have little effect unless
the state withholds the relief it can afford and
which it seems already committed to provide."
Proposition 13 thus emerges as a tax-reform
rather than an expenditure-reduction measureone which shifts the emphasis from the property
tax to the income tax. Moreover, by shifting a
major portion of local revenue-raising responsibility to the state, the amendment tends to erode
local control. (In view of recent court decisions,
this process would have occurred in any event
with respect to education.) And since the property taxes that remain are shared on a countywide basis, the measure tends to augment the
resources of fiscally weak governments at the
expense of the more affluent.
Oakland emphasizes that the combination of
factors which gave rise to Proposition 13 is
unlikely to be matched in many other statesand the same can be said of its consequences.
"The existence of a significant state surplus has
mitigated its potentially disruptive impact upon
the delivery of public services. This carries an
important lesson for other states that have !J,een
considering measures similar to Proposition 13.
Unless a considerable surplus already exists
somewhere in their state-local system, they cannot expect to match the relatively smooth transition experienced by California."
Jack H. Beebe notes that Proposition 13, in
addition to restricting revenue sources, also
5
corporate financing from large banks to the
commercial-paper market. This increased reliance on direct finance through financial markets
goes against the typical postwar pattern, which
involves an increasing scope for financial intermediaries in channeling credit. In Judd's view,
"This development stems from the unavoidable
higher costs of bank as compared to papermarket credit, as well as the relatively low value
of the intermediation 'services' which banks can
provide to commercial-paper borrowers."
Judd asks why large corporations did not
switch to the commercial-paper market at some
earlier date. "First, given the consistently low
interest rates of the 1950's and early 1960's, they
did not feel justified incurring the costs of developing and maintaining the staff expertise to
actively manage liquid assets and liabilities."
Corporations established a pattern of dealing
primarily with banks, even though deposit yields
were somewhat lower, and loan rates somewhat
higher, than those in the open-market. "Second,
even after interest rates began their secular rise in
the mid-1960's, corporate borrowers remained
uncertain about switching to the paper market,
because this meant departing from (and possibly
damaging) long-standing and difficult-toreplace bank relationships."
Judd emphasizes that the greatly reduced
availability of bank credit in the credit
"crunches" of 1966 and 1969-70 created a new
financial environment. "Once having overcome
the obstacles to paper-market entry, eligible
firms became very responsive to relative costs in
deciding between alternative means of finance.
And since bank credit is almost unavoidably
more expensive than paper-market credit, the
switch to the latter market is not likely to be
reversed in the foreseeable future."
restricts increases in the state's taxing powers--and thereby blocks large increases in state taxes
as an alternative source of government revenue.
"Since such restrictions should affect the ability
of municipalities to service and retire debt,
Proposition 13's passage may adversely affect
both the cost of new issues and the value of
existing California municipal debt."
Beebe shows that Proposition 13 affects particular kinds of municipal debt in different ways
because of the specific wording of the amendment. "For example, debt secured solely by
property-tax revenues is severely affected, while
other kinds of debt backed by general tax revenues are affected less or not at all." The principal
debt-market casualties appear to be redevelopment agencies, the principal issuers of taxallocation issues, which have suffered an increase
in risk premium of at least 250 basis points
because of the financial market's reaction to
Proposition 13.
Beebe suggests, however, that restrictions on
the size of government need not increase the cost
of new debt or decrease the value of existing
debt. "Funds needed to payoff all existing debt
could be exempted from revenue ceilings (as was
voter-approved debt under Proposition 13),
thereby protecting all debt. Voters and government officials may wish to consider such alternatives in structuring ways to restrict government."
The articles by Oakland and Beebe indicate
that notable changes have occurred to the statelocal fiscal structure in an era of high inflation. A
third article in this issue, by John P. Judd,
analyzes an important change that has occurred
in the nation's financial markets in the past
decade's environment of inflation and high interest rates-the shift of a major portion of large
6
1
William H. Oakland*
that slightly more than half of the lost $7 billion
would have been spent on payroll (the national
average is 57 percent). The total employment loss
was estimated at 400,000 public and private jobs,
allowing for such indirect effects as the money
public employees would no longer spend.
Equally important, the critics predicted that a
massive disruption of public services would
accompany the revenue shortfall. San Francisco
officials, for example, estimated that outlays on
police and fire services would be cut by onethird, the budget for libraries cut by 80 percent,
the city zoo entirely eliminated, and funds for
other recreation and cultural activities reduced
by two-thirds. 4 These dire forecasts have not yet
materialized, because of substantial State
relief-and because of a number of other factors
discussed in this paper. However, the critics
argue that severe consequences can still be expected, since the State program was only enacted
for one year and the surplus from which it was
financed may not recur.
While Proposition 13's employment and
public-expenditure effects have received the
most attention, numerous other ramifications
also demand attention. The amendment, for
example, has major implications for financial
markets, for individual taxpayers, for the housing market, for state and local governments, and
perhaps, most dramatically, for the Federal
Government. Because of this complexity, it
would be foolish to attempt a comprehensive
evaluation in the space available here. Instead,
the paper will focus upon three broad questions
or tssues:
1. What was the general fiscal climate during
the period in which the amendment was formulated and debated?
2. To what extent will Proposition 13 succeed
in reducing the size and growth of California's
public expenditures?
California's voters recently enacted a revolutionary measure for reducing the level and
growth of state-and-local government expenditure, and for sharply restricting the use of the
property tax as a source of government revenue.
The Jarvis-Gann Amendment (Proposition 13):
(1) restricts the property tax rate to no more than
one percent of assessed value; I (2) sets assessed
value for a property which has not been transferred since 1975-76 equal to its 1975-76 fairmarket value plus two percent per year
(compounded)-or in the case of subsequent
transfer, sets assessed value equal to market
value at time of sale plus the two-percent growth
factor; and (3) requires that new taxes or increases in existing taxes (except property taxes)
receive a two-thirds approval of the legislature in
the case of state taxes, or of the electorate in the
case of local taxes. 2
These provisions have had an enormous fiscal
impact. First, the rate limitation alone cut
property-tax collections by half,3 since the effective rate of property tax previously had averaged
about 2.5 percent statewide. Moreover, the reduction was accentuated by the fact that the
rollback of assessments applied to a period when
property values had escalated rapidly. Hence,
the overall impact amounted to a 57-percent ($7
billion) reduction in property-tax receipts. This
constituted nearly 20 percent of the total revenues raised by all levels of California governments, and 37 percent of the revenues raised by
local governments alone.
Before the fact, Proposition 13's critics had
predicted disastrous fiscal consequences from
such a massive reduction in local-government
revenues. They predicted a loss of more than
200,000 public-sector jobs, on the assumption
*
Professor of Economics and Public Administration, Ohio
State University. and Visiting Scholar. Federal Reserve
Bank of San Francisco. Summer 1978.
7
3. What does the amendment imply for California's future revenue structure?
The answer to the first question should help to
resolve a basic controversy-was Proposition
13's success due to fiscal conditions characteristic of state-and-local governments in general, or
was it simply a response to fiscal tensions unique
to California? The evidence presented below
supports the latter position. More specifically,
we argue that California's fiscal climate in the
pre-Proposition 13 period was characterized by:
a) a heavy and growing state-and-Iocal tax burden during a period when such burdens had
levelled off in most other states; b) a massive shift
of property taxes towards homeowners; and c) a
rapidly expanding State budget surplus.
Although difficult to quantify, each factor
undoubtedly contributed to Proposition 13's
emergence and eventual adoption. More importantly, however, the second and third factors
were almost unique to California. The fact that
other states considered similar measures, therefore, is more a reflection of their attempt to
replicate California's "success" with voterinduced tax reduction than a response to similar
fiscal pressures. Largely for this reason, California's experience provides little guidance for other
communities. For example, unless they amass a
substantial budget surplus somewhere in the
state-local fiscal system, as California has done,
they cannot avoid painful disruptions in public
services.
This leads us to the second question-the
impact on the size and growth of public expenditure. Some Proposition 13 advocates have argued that one of its major effects will be a curb on
the growth of the public sector. Our evidence
suggests that such effects are and will continue to
be relatively minor. Specifically, in its first year,
Proposition 13 reduced the level of public services by roughly 3 percent, and in subsequent
years, it may reduce the growth rate of public
services by less than I percentage point. Such
results primarily reflect the significant earlier
build-up in the State government's budget surplus, the highly responsive character of the State
revenue system, and the substantial growth expected in future property-tax revenues.
Despite this small expenditure impact, Proposition 13 has affected the revenue structure of
California governments in a major way. Because
it largely substitutes State revenues for local
revenues, the share of local-government expenditures financed by local sources has dropped
precipitously. This has obvious consequences for
home rule. In addition, the progressivity of the
state-local revenue system has increased, because
State revenue sources tend to be more progressive than the local property tax. Finally, property-tax proceeds have come to be shared, on a
defacto basis, by local-government units within a
county area. In effect, Proposition 13 has introduced tax-base sharing at the county level. This
important (although unintended) effect has
tended to strengthen fiscally weak jurisdictions
(e.g., central-city governments) at the expense of
the more affluent (e.g., suburbs).
I. Califomia Tax Climate
In this section we focus upon three major
facets of California's fiscal climate: (1) the behavior of the total state-local tax burden over the
past two decades; (2) the behavior of the relative
property-tax burden of owner-occupied residential property; (3) the recent growth of the State
surplus and fiscal prospects for the near-term
future.
only Alaska ($1,896) and New York ($1,139).
Accordingly, per capita taxes in California stood
32 percent above the national average and 44
percent above the state median. In relation to
personal income, a similar picture emerges.
Californians paid 14.9 percent of their personal
income in ! 975-76, ranking behind only New
York and Vermont residents-and standing 19
percent above the national average. Thus, regardless of the measure, California emerges as a
high-tax state.
Additionally, the tax burden has increased
sharply in recent years. Without Proposition 13,
California governments would have absorbed
Total state-local tax burden
California governments collected $20.8 billion
in taxes in fiscal year 1975-76, more than their
counterparts in any other state. s California's per
capita tax collection of $965 placed it behind
8
nearly 16 percent of the state's personal income
in fiscal year 1978-79, as compared to 9.3 percent
in 1957-an increase of more than 6.5 percentage
points. (Table A.l and Chart I). For the U.S. as a
whole, this measure also increased during the
period, but at a much less rapid pace. Thus, the
differential between California and the rest of the
nation widened from I percentage point to more
than 4 percentage points over the past two
decades, with much of that widening occurring
just within the past five years. While the effective
tax rate elsewhere actually decreased slightly
during the seventies, California's effective rate
continued to grow as rapidly as before. This
suggests that California has gotten out of step
with the rest of the country in recent years.
Proposition 13 may thus reflect taxpayers'
attempts to bring their government back into line
with historic relationships.6 But even after the
adoption of the amendment, as Table A.I indicates, California's tax rate remains above the
average for the rest of the nation.
Property tax burdens
Consequently, significant pressures for tax
relief have developed in California during recent
years. But where would we expect those pressures to erupt? The sharpest increase in recent
years has occurred in property taxes, especially
those affecting homeowners. Thus, it is not
surprising that the taxpayer chose this particular
avenue for tax reduction.
The property tax plays a major role in the
California tax structure, comprising approximately 41 percent of total state-local tax revenue
in 1975-76. 7 The corresponding figure for the
U.S. as a whole is 36 percent. 8 And since California is a high tax state, its property-tax burden is
relatively high. In per capita terms, California's
1975-76 property tax receipts of $415 stood 47
percent above the national norm, and were
surpassed only by New Jersey ($446) and Alaska
($1,048). 9 As a share of personal income, the
relevant figures are 6.4 percent for California
and 4.5 percent for the nation as a whole (see
Appendix Table A.2 and Chart I). The introduction of General Revenue Sharing narrowed this
gap in the early seventies, but it widened again
after 1973.
The growing burden was especially heavy for
homeowners. In the absence of Proposition 13,
Chart 1
Property Taxes, and Total State-Local Taxes,
as Percent of Personal Income
Percent
16
Total State-Local Taxes
12
8
4
U.S. less California
Property Taxes
o
1957
Source:
,,I
I
1964
I
I
1967
I
I
1970
I
I
1973
I
I
1976
I
I
1979
u.s. Bureau of Census; 1977-79 data estimated by author (see Tables A.1 and A.21. Effect
of Proposition 13 not shown on chart.
9
the share of property taxes accounted for by
single-family dwellings would have risen from 32
percent in 1973-74 to 44 percent in 1978-79
(Table A.3 and Chart 2). Thus, relative to total
state personal income, homeowner property
taxes increased 38 percent over the same period. IO The single-family share of total assessments
had been relatively constant during the sixties
and early seventies, despite substantial adjustments in the shares of other types of property.
Indeed, an increase in the homeowner's exemption caused the share to dip momentarily in 197374, but then it began a rapid rise because of an
unparalleled boom in the single-family housing
market. Prices for existing homes in the San
Francisco area, for example, jumped 120 percent
between April 1973 and April I978-roughly 18
percent a yearll-and the Los Angeles area
experienced even faster growth. The price upsurge could not be attributed to inflation alone,
since the GNP price deflator increased only 55
percent over the same five-year period. The
boom was confined primarily to single-family
housing, and did not spill over into nonresidential building.
Because reassessment in California is conducted on a three-year cycle, the full effects of the
housing price upsurge had not yet been felt by the
fiscal year 1978-79. Given a 9-percent annual rate
of property appreciation-a conservative
estimate-and given a continuation of the recent
pace of construction activity, the single-family
share of assessments (without Proposition 13)
would have risen to about 48.6 percent in the
year 1981-82. (In contrast, the combined share of
assessments, for homeowners and renters alike,
amounted to only 47 percent for the nation as a
whole in 1975.)12 In the space of only seven years,
then, the homeowner's share of the property tax
would have risen 54 percent.
Therefore, it is not surprising that California's
taxpayer revolt focussed upon property-tax reduction. The property-tax burden generally was
heavier than elsewhere, and in addition, the
rapid escalation of real-estate prices had created
a massive shift of the property-tax burden toward homeowners. As a class, homeowners were
made better off by the capital gains on their
homes, but most were not in a position to realize
them. Consequently, a large number of homeowners found themselves with property-tax bills
doubling and even tripling without a corresponding increase in their income flow. Thus
considerable pressures arose for some form of
property-tax relief.
Chart 2
Single-Family Dwellings: Share of Property Taxes,
and Tax as Percent of Income
Percent
Percent
40
4
3
Share of Property Taxes
30
~
2
-- Tax as Percent of Personal Income
California
o
1965
1970
1975
1980
Source: California Board of Equalization; author's estimates for 1976-79 (see Table A.3).
10
State budget surplus
No story about California's fiscal climate
would be complete without a discussion of the
budget surplus accumulated by the State government in the past several years. Without the
passage of Proposition 13 and its impact on the
1978-79 budget, the cumulative surplus would
have grown to at least $10.1 billion by 1979-80
(Tablel)l3. That amount would have been almost as great as the combined yield ($11 billion
in 1979) of the State's two major revenue sources,
the personal income tax and the general sales
tax. 14
The growth in the State surplus reflects a
virtual explosion of California tax revenues
(Table 2). Between 1975-76 and 1977-78, three of
the State's major revenue sources showed growth
rates of 43 percent or more, and a fourth grew by
about one-third. Overall, growth of revenues
amounted to a staggering 40 percent. More
impressively, this growth was accomplished
without any rate increases and was accompanied
by an increase of only 23 percent in state personal
income. In the aggregate, the latter implies a
revenue elasticity of 1.75. Although State expenditures also grew rapidly over the same
period (27 percent), this growth was not sufficient to prevent the accumulation of a considerable surplus.
The rapid growth of State-tax revenues can be
explained in part by the rapid recovery of the
national and regional economies from the severe
1974-75 recession. Corporate profits and per-
Table 1
BUdget Surplus of the State of California,
Prior to Adoption of Proposition 13,
1975-76 to 1979-80
($ millions)
Cumulative
Surplus
At Beginning
of Fiscal Year
Fiscal Year
Change in
Cumulative
Surplus from
Preceding Year
1975-76
570
641
1976-77
1,211
1977-78
3,800
2,589
1978-79a
7,100
3,300
I979-80 a
10.100
3,000
a Does not allow for $4, 100 million Proposition 13 reliefand
temporary income-tax cut of$1 ,000 million, both for fiscal
year 1978-79.
Source: (1975-76) and (1976-77), California Legislature,
Analysis ofthe Budget Bill, July I, 1978 to June 30,
1978; (1977-78) to (1979-80) San Francisco Chronicle. August 25, 1978.
sonal income, of course, are highly sensitive to
aggregate economic conditions. But as the economy approaches full-employment, revenue increases from these sources should slow down.
However, one other factor tends to keep state
revenue growth above that of personal income-inflation. Since the State's personal income tax is
steeply progressive over a wide range, increases
in income due to inflation generate disproportionately large increases in tax receipts. Specifically, the elasticity of the State income tax with
Table 2
Growth of Major State Taxes in California
1975-76 to 1977-78
Tax Source
Personal Income Tax
General Sales Tax
Selective Sales Taxes
Corporation Income Tax
Death and Gift Taxes
Property (auto excise) Tax
TOTAL
Receipts
1977-78
($ millions)
Change Since
1975-76
($ millions)
Percent Growth
1975-76 to 1977-78
(percent)
$ 4,391
5,020
2.234
1,900
369
445
$ 1,432
1,278
672
616
48
70
48
34
43
48
14,359
4,116
40
17
19
23
Item: California Personal Income
Sources: U. S. Bureau of the Census, Governmental Finances; Economic Report of the Governor, 1978.
11
Table 3
Projected BUdget Surplus of
the State of California
1978-79 to 1983-84
($ millions)
respect to personal income has averaged about
1.7 over the last decade. This means that for
everyone-percent inflation-induced growth in
personal income, income taxes have increased by
1.7 percent- a 0.7-percent bonus for the State.
At inflation rates of 7 to 8 percent, this translates
into an additional 5-percent real increase in the
State government's revenue.
Inflation makes the short-term outlook for
State revenue growth particularly bright. Continued inflation should enable the State to sustain personal-income growth of II percent, its
average for the past five years. If the growth of
other tax revenue matches the growth of personal income, total tax reveI1ue could expand
13.5 percent per year-nearly doubling within
five years. 15 More importantly, if State Government expenditures grow in proportion to State
personal income, the budget surplus would continue to expand. By the year 1983-84, the annual
surplus would rise to $6.3 billion, and the cumulative surplus to more than $30 billion (Table 3).
In other words, the budget surplus would grow
to untenable levels without some action to reduce taxes. Of course the State government
could increase expenditures more rapidly than
the II percent assumed in our projections. But
this would run counter to the national trend-a
falling share of income absorbed by state and
local taxes (see Table A.I). The State,
alternatively, could provide greater financial
relief to local governments, but this would only
shift the locus of the surplus. Tax reduction of
some form appears inevitable. Indeed, this helps
explain the recent one-time-only State income
tax cut of $1 billion, at a time when governlllent
finances were supposedly in a state of crisis. A
glance at Table 3 suggests that this action was no
more than a "drop in the bucket."
Fiscal
Year
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
Cumulative
End-of-Year
Yearly
Surplus a
Surplus a
$ 7.100
11.202
15.767
20.846
26,489
32,780
$3.300
4.102
4.565
5.079
5.653
6.291
a For derivation see text. No allowance is made for State
relief or tax-cut programs enacted for fiscal year 1978-79.
this amounted to resistance to abnormally high
levels of government expenditure. 16 At the same
time, the combination of economic recovery and
inflation had produced a substantial budgetary
surplus which, if left unchecked, would have
soon grown to unreasonable proportions.
Hence, pressures were building to bring taxes
back into line with expenditure. Finally, a boom
in the single-family housing market produced a
sharp jump in the homeowner's share of the
property-tax burden. Thus, there was considerable pressure to provide tax relief to this subset
of taxpayers. 17
Proposition 13, then, was California's method
of dealing with these diverse pressures. It accomplished the necessary tax reduction, and at the
same time provided a change in tax structure
designed to promote equity. This is not to say,
however, that the amendment was the optimal
way of achieving these goals. The fact that no
provision was made for a redistribution of taxes
from the State to local governments threatened a
considerable disruption in the delivery of public
services. However, given the diverse objectives to
be served and differences of interests among
voters, a comprehensive approach may not be
proven politically feasible. Moreover, the State
did redirect substantial revenues to local government. Viewed in this light, Proposition I3 was
successful in liquidating the State surplus.
Three major factors
We can now weave together the three major
strands of our fiscal-climate story. Not only were
taxes considerably higher in California than
elsewhere, but they were also diverging from the
national norm. Pressures therefore were developing to bring the state back into line. In effect,
II. Expenditure Impacts
More than anything else, Proposition 13 has
been interpreted as a measure to reduce the level
and control the growth of government spending.
In this section, we offer quantitative estimates of
12
ity of police and fire services as a condition for
receiving emergency State assistance.
For those reasons, uncontrollable expenditures may amount to as much as 60 percent of
local budgets. Hence, the remaining 40 percent
would have to bear the full brunt of the $2.9billion revenue shortfall. This would involve cuts
of nearly 25 percent-not 9.5 percent-so that
serious disruptions could be expected to follow.
Despite these somber circumstances, localgovernment employment dropped by only 7,000
workers during July, the first month of operation
under Jarvis-Gann. 19 With a $2.9-billion shortfall, local employment presumably eventually
would have had to drop by 80,000, more than ten
times what actually occurred. (Even though the
7,000 drop reflects only the first month under the
amendment, its permanent character would require much of the adjustment to be made early.)
While local governments undoubtedly have
some flexibility in substituting workers for other
inputs, reducing overtime, etc., a discrepancy of
73,000 could not be due to such factors. Rather,
the discrepancy must be explained in terms of an
error in the official projection-in other words,
the $2.9-billion figure is a gross exaggeration of
the local-government revenue gap.
the expenditure impacts of the amendment in
both the short and medium term. It will be seen
that the pre-election estimates were grossly exaggerated, and that Proposition 13's impact on the
size of California's public sector has been relatively modest. (For those readers who wish to
skip the sometimes complex detail, the main
conclusions are summarized in the last part of
this section.)
Early estimates of impact
As noted earlier, the Jarvis-Gann Amendment
initially had been expected to reduce localgovernment property-tax revenues by 57 percent
($7 billion) in fiscal year 1978-79. This would
imply a 23-percent reduction in local expenditures, allowing for the fact that the property tax
produced 40 percent of all local revenues. A
reduction of such magnitude was not required,
however, because the State government, by
liquidating some of its surplus, allocated $4.1
billion in direct assistance and $0.9 billion in
emergency loans to local governments. Actually,
the State relief package amounted to only $4.1
billion, since no local units availed themselves of
the loan funds, which would have required
repayment in any case. With the $4.1 billion in
hand, local governments faced a projected revenue shortfall of $2.9 billion in the first year after
the passage of Proposition 13-which implies a
9.5-percent reduction in total expenditures.
An across-the-board cut of 9.5 percent would
appear to be manageable, although somewhat
painful. However, the problem is complicated by
the fact that a large fraction of local expenditure
is outside the control of local authorities, because of Federal or State mandates and/ or grant
funds which are not fungible. Consider for example, public welfare. Half of the welfare program's
support comes from the State, and support levels
and eligibility requirements are determined by
Congress and the State Legislature. Hence, the
major discretion left to the localities lies with
administration, which amounts to less than 5
percent of total welfare outlay. IS And efforts to
trim administration may backfire, because payments to ineligible households could increase
without proper supervision. The problem is
further complicated by the legislative requirement that local communities maintain the qual-
Impact on existing service levels
There are two ways to estimate Proposition
13's public-expenditure impact. The first is to
compare public-service levels with those which
had prevailed in fiscal year 1977-78, the year
prior to implementation of the amendment. This
comparison would help measure the magnitude
of the disruption in the flow of public services
resulting from the action. A second approach is
to compare public services with what they would
have been in the absence of Proposition 13,
which should enable us to discern the expenditure impact of the amendment. Clearly the two
measures will be the same if the level of public
services remains constant over time. However,
some growth in public services has been occurring and can be reasonably expected to continue
into the future. For these reasons, both measures
are examined below.
First, consider the impact on the existing level
of public services. Between the 1977-78 and 197879 fiscal years, Proposition 13 was expected to
13
both such cases, Proposition 13 allows assessors
to adjust prevailing assessments for past errorsand as a result, a large number of properties
showed higher assessments after larvis-Gann
passed than they would have in its absence. 21
Consequently, property-tax revenues in fiscal
1978-79 will be $405 million higher than initially
projected. 22
A further adjustment must be made to allow
for the growth of non-property tax revenues.
Since the latter are not directly affected by the
amendment, we assume that they will grow by 10
percent between 1977-78 and 1978-79-their
average rate of growth since 1974-75. 23 This will
produce an additional $1,716 million for use in
1978-79. Thus, the net change over the year in
tota/local government revenue amounts to $173
million.
To complete this calculation, we must compute the growth of revenues which would have
been necessary to sustain 1977-78 public-service
levels. With an 8-percent expected rate of inflation, a revenue increase of $2,288 million would
be necessary to maintain services. However, as
part of its relief measure, the State Legislature
prohibited cost-of-living adjustments for localgovernment employees, so that extra revenues
would be needed only for the increased costs for
materials and supplies. Since wages comprise 55
percent of total expenditures, the requisite increase is only $1,030 million. 24 Thus, the overall
revenue deficiency is $857 million ($173 million
less $1,030 million), or 2.8 percent.
It could be argued that the wage freeze will
have to be made up sooner or later, and should
therefore be excluded from consideration. This
objection would be valid if local governments
purchased labor services on competitive markets. However, wages in California's public
sector run 23 percent above the national ayerage,25 while wages in its private (manufacturing)
sector run only 9 percent above the national
average. It would seem, therefore, that California's public-sector workers could live with a oneyear wage freeze, because their wages are considerably above those dictated by a free market.
In summary, Proposition 13's actual effect was
only a 2.8-percent reduction rather than the 23percent initially-estimated shortfall in localgovernment revenues. Even allowing for the fact
reduce local-government revenues by. $6,048
million (Table 4). From this must first be subtracted the State relief package of $4, 100 million.
But a second adjustment must be made for the
fact that officials underestimated actual
property-tax collections for 1978-79. Because of
the rollback in assessments required by. the
amendment, officials projected the growth of
assessments at only 1.3 percent, as compared to
the 12.5 percent which would have been expected
in the absence of Proposition 13. 20 In fact, fiscal
1978-79 assessments increased by a healthy 9
percent.
This discrepancy reflected the fact that, despite a three-year reassessment cycle, many properties had been underassessed relative to their
1975-76 values as late as the Spring of 1978, when
the rolls for the 1978-79 fiscal year were taken.
Furthermore, because of the assessment lag,
many of the properties transferred during the
1975-78 period had not been reassessed at their
value at time of sale. Since market values had
escalated rapidly during this period, the degree
of underassessment would be considerable. In
Table 4
Reduction in the Average level of
local Public Services Caused by
Proposition 13
($ millions)
Changes in Local Revenues
Caused by Proposition 13
$11,452
1977-78 Property Tax Collection
1978-79 Officially Estimated Property
5,404
Tax Collections
-$6,048
Net Change
Adjustments
State relief
Additional Property Tax Revenue
Due to Higher Assessments
Total
4,100
405
4,505
1,716
Projected Increase in Other Revenues
1977-78 to 1978-79
Net Change in Revenues
Changes in Revenue Necessary to Maintain
1977-78 Service Levels
.08 x 1977-78 Expenditure
Less Wage Share (55%)
Revenue Deficiency
Percent Revenue Deficiency
173
2,288
1,258
1.030
857
2.8%
14
TableS
Local Public Expenditure Before
and After Proposition 13 (1978-79)
($ millions)
that mandated programs pushed the brunt of the
adjustment upon 40 percent of local governments' budgets, the implied reduction amounted
to 7.0 percent for those activities subject to cuts.
Such an adjustment would seem to be achievable
without major disruptions. And since many local
governments responded to the revenue shortfall
by imposing new schedules of fees, much of the
remaining reduction may yet be avoided. 26
The employment data cited above are consistent with this finding of ~nly small impact of the
Jarvis-Gann amendment on the level of public
services. Further support is provided by the
budget of the City and County of San Francisco.
Although accounting procedures make year-toyear comparisons difficult, San Francisco's total
budget showed only an $8-million decline, to
$823 million, for fiscal 1978-79. Moreover, the
budget for permanent employees' salaries
remained unchanged from a year earlierimplying no layoffs. Furthermore, the City rescinded several emergency tax measures adopted
at the time the amendment was first passedwhich would hardly imply fiscal distress. Finally,
there is some evidence that the City actually
budgeted a considerable surplus for the year. 27 , 28
Changes in Local Revenues
Caused by Proposition 13
Officially Estimated 1978-79
Property Tax Collections
$12,448
Officially Estimated 1978-79 Property
Tax Collections Under Proposition 13
5,404
7,044
Less:
State Relief
Additional Property Tax because of
Higher Assessments
Savings because of Prohibition on
Cost-of-Living Increases
4,100
405
1,258
TOTAL
5,763
Net Revenue Shortfall
1,281
Projected 1978-79 Local Revenue
Percent Net Revenue Shortfall
31,473
4.0%
without Jarvis-Gann-only a 4.0 percent shortfall from projected 1978-79 revenues. That cutback seems modest, indeed, when compared with
the figures seen in the popular press-or when
compared with what Proposition l3's supporters
had hoped to achieve.
Impact on 1978-79 service levels
To determine the amendment's impact on
1978-79 planned local expenditures, we must
calculate the loss of local revenue caused by
Proposition 13 plus any State-mandated expenditure cutbacks (Table 5).29 According to
official estimates, the 1978-79 property-tax revenue loss amounts to $12,448 million, but from
this we subtract State relief and the property-tax
receipts not officially anticipated. The resulting
figure, $2,469 million, is thus a first approximation of the reduction in local-government revenues from what would have prevailed without
the amendment.
This figure overstates the impact on public
services, however, because it fails to allow for the
wage freeze imposed by the State Legislature.
This action freed up funds which could be used
for other purposes, and is thus tantamount to a
State grant to local governments of an amount
equal to the wage savings. Hence, it must be
subtracted from the revenue shortfall. This yields
a net reduction in public services of $1,281
million from the level that would have prevailed
Future service-level impacts
Even though the first-year expenditure impact
is minimal, it could be argued that Proposition
13 will still have a major impact in subsequent
years. This view is based upon several considerations: (I) the State relief package was for a single
year only; (2) the State surplus from which
existing relief was drawn will be depleted in
future years; and (3) the amendment's restrictions on assessments will inhibit the future
growth of property-tax receipts.
A crucial question concerns the magnitude of
surplus State funds, which helps determine the
availability and the extent of future State assistance. Some analysts believe only modest
amounts will be available, especially since the
surplus available to the State Legislature in July
1978 was the result of several years' accumulation. However, there is ample reason to believe
that the State could continue or even increase
15
existing levels of assistance without increasing
tax rates. To analyze this possibility, we project
the State surplus under two alternative sets of
assumptions about the growth of personal income and State relief. The first assumes growth
rates of 12 percent and 10 percent, respectively;
the second uses 10 percent and 8 percent.
How valid are these assumptions? While 12percent personal-income growth is slightly higher than the II percent experienced over the past
five years, the recent upsurge in inflation makes
such an assumption quite plausible. The 10percent growth in aid, on the other hand, would
correspond to the pre-Proposition 13 average
growth of property-tax receipts. If State. aid
grows at a 10-percent rate, therefore, any reduction in the growth of local expenditures would be
the result of the failure of locally raised revenues
to keep pace with the growth they would have
experienced without the amendment. The second set of assumptions is more conservative. The
10-percent personal-income growth figure has
been surpassed every year since 1973, and the 8percent growth of State aid would do nothing
more than maintain the real value of relief under
present inflationary conditions.
State expenditures are assumed to grow at the
rate of personal income, while revenues grow at
the same rate multiplied by the revenue elasticity,
following the procedure used for Table 5. However, we must also adjust for two postProposition 13 developments-the one-timeonly tax cut of $1 billion, and the indexation of
income-tax brackets for the first three percentage points of inflation. Hence, we reduce the
elasticity of the income tax from 1. 7 (as in Table
5) to a figure of 1.5, and thus obtain a total State
revenue elasticity of 1.166.
Under the first set of assumptions, therefore,
the State can adequately fund the program
without an increase in tax rates (Table 6),30
Although annual expenditures would exceed
revenues between 1978-79 and 1984-85, the carryover surplus would be sufficient to fund the
deficits-and thereafter, annual revenues would
begin to exceed expenditures. Under the second
set of assumptions, cumulative deficits would
begin to emerge in the mid-eighties, but the $170million deficit in 1984-85 would amount to only
.006 percent of State revenue and 2.6 percent of
the State relief program. Since the deficit would
disappear by the following year, the program
appears to be fundable.
Whether or not the State can offset a constant
proportion of local-government property-tax
losses, then, hinges critically upon the growth of
Table 6
Projected SurplUS of the State of California, *
1978-79 to 1986-87
($ millions)
Assumption A
Fiscal
Year
Assumption B
Yearly
Surplus
Yearly
Surplus
Cumulative
Surplus
-$1,800a
-468
-427
372
-298
203
-83
65
n.c.
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
!985-86
!986-87
Cumulative
Surplus
$2,000
1,532
1,105
733
435
232
149
214
n.c.
-$ 1,800 a
516
474
420
354
-271
-170
49
96
$2,000
1,484
1,010
590
236
35
-205
-254
-158
Assumption A:
12-percent growth of State personal income and !O-percent growth of State aid.
Assumption B:
IO-percent growth of State personal income and 8-percent growth of State aid.
n.c.Not calculated
a Rellects a $I-billion tax cut for 1978-79 only.
*Source: see derivation in text.
16
personal income. If this growth is as high as 12
percent, the State can meet its objective without
an increase in statutory tax rates. If, on the other
hand, income growth is only 10 percent, aid can
grow at only 8 percent per year. In other words,
relief would fall 2 percentage points below the
level necessary to keep local public expenditures
growing at the rate which would have prevailed
in the absence of Proposition 13. 31
Another crucial question concerns the potential problems caused by the amendment's 2percent annual limit on property reassessments
(unless the property is transferred). On its face,
this might seem to limit property-tax revenue to
2-percent annual growth, but such is not the case.
The growth of property-tax receipts will reflect
the degree of underassessment as of 1978-79, the
rate of increase of property values, the turnover
rate of existing property, and the rate of new
construction.
COIlsider, first, the growth of residentialproperty assessments. As the appendix shows,
aggregate assessments for existing houses could
grow at a rate equal to 90 percent of the underlying appreciation rate of housing prices in thefirst
year following the reassessment limitation.
Moreover, in subsequent years, assessments
could continue tb increase until reaching the
appreciation rate. Thus, if housing values are
increasing at a 10-percent annual rate, the assessed value of the housing stock in place during
1978-79 will grow by 9 percent in 1979-80. These
results are based on two assumptions, both of
which conform with recent experience-a 25percent initial under-assessment of the existing
housing stock, relative to its 1978-79 value, and a
15-percent annual turnover rate of existing housing. 32
The rapid increase in the assessed value of the
existi~ghousing stock reflects the much larger
(although less frequent) reassessment of homes
under the amendment. For example, if a house is
sold every seven years and housing prices grow at
10 percent per year, the assessed value of such a
house will double at the time of sale. If, on the
other hand, the house were assessed annually,
the increase in assessment would be only 10
percent each year, leading to the same result over
time. Thus, Proposition 13 would cause a much
smaller reduction in the growth of the assessed
value of existing homes than perhaps some of its
framers intended. We must also consider the
growth caused by new construction, which
amounts each year to between 2 and 4 percent of
California's existing housing stock. If housing
prices rise 10 percent per year, which is modest
by recent standards, the total residentialproperty tax base will then increase by II to 13
percent per year, not much below its recent
performance.
The situation is much different with nonresidential properties, which are transferred
much less frequently than housing. Hence, the
taxable base for this class of property probably
will grow at about the 2-percent allowable annual rate, plus any growth due to new construction,
which normally accounts for about 2 percent of
the existing stock. Thus, we could expect the
non-residential property tax base to rise about 4
percent annually.
The total property-tax base, given our assumptions about the growth of the (relatively
comparable) residential and non-residential
components, could increase annually by 71;2
percent to 81;2 percent-say 8 percent. This is
only 2 percentage points below what would have
been expected without Proposition 13. But this
gap will now pose a much less serious problem
than before, because the property tax now accounts for only 20 percent of total localgovernment revenues, as compared with 40 percent in the pre-amendment period. This means
that the annual revenue shortfall caused by the
reassessment provision should amount to only
0.4 percent-scarcely a startling effect.
Under our assumption of 10-percent annual
growth in state aid, the reduction in the growth
of public expenditure would reflect the reassessment provision alone--only 0.4 percent. But
with 8-percent annual growth in state aid, the
total reduction will be 0.7 percent. 33 By either
standard, the reduction appears insignificant in
relation to the IO-percent anticipated annual
growth in local public expenditures.
Overall impact
Altogether, Proposition 13 has had, and will
probably continue to have, only minor effects
upon the size of California's public sector.
Public-service levels in 1978-79 are only about
2.8 percent below those prevailing in the year
17
before the amendment took effect~oronly
about 4.0 percent below if allowance is made for
increases in public services which would have
occured in the absence of Jarvis-Gann. The
future expenditure effect, on the other hand,will
hinge largely upon what happens to the State
relief program. Since the State will probably
continue to amass surpluses, it will probably
continue to make aid available to local governments. The major source of expenditure constraint, however, will be the slowdown in the
growth of property-tax revenues. But even this
shortfall should amount to only 0.4-0.6 percent
of the total revenue requirement oflocal governments. And in view of the availability of other
revenue sources-such as charges, fees, and wage
taxes-even this minor shortfall could be
resolved.
Two caveats are in order, however. First, our
calculations were done entirely at the aggregate
level, whereas some individual government units
could experience considerable reductions in expenditure. Secondly, no allowance was made for
the possibility of recession. A major recession
could wipe out much of the carryover surplus
which is providing the funding for the State relief
program. However, even during the 1975 recession, California personal income grew by 1012
percent-which is above our minimum-growth
assumption. This reflected the inflation which
kept nominal incomes rising in the face of recession. Since substantial inflation could continue
for the next four or five years, even the occurrence of a recession during this period need not
invalidate our conclusions.
III. TaX Structure Impact
In contrast to Proposition 13's relatively
minor impact upon the level of government
expenditure, it will have a substantial impact
upon the state-and-local tax structure, and also
upon the distribution of revenue-raising responsibility between the State and local governments
(Table 7). The local share of total revenues in
1978-79 drops 12 percentage points, to 37 percent, as a result of the amendment. (In contrast,
the national average share was 46 percent in
1975-76.) This understates the extent of the
actual reduction, however, because without the
amendment the State would probably have taken steps to liquidate its surplus. With a $4.1billion reduction in the surplus-the actual
amount of local relief-the local share of statelocal revenue would have been considerably
higher, so by that standard Proposition 13 lowered the local share by nearly 20 percentage
points. And the situation is even more dramatic
for specific local functions. For example, the
share of education financed locally drops from
Table 7
State-local Division of Revenue Raising Responsibility
in California, 1978-79
Source of Total Own-Source Revenue
($ millions)
Without Amendment
Without
With
Tax Reduction
Tax Reduction'
(1)
Local
$16.983 (49%)
State
17.675 (51%)
Total
34.658
Share of Elementary and
Secondary Education Costs
With
Amendment
With
Amendment
(3)
(4)
(5)
$10,483 (37%)
520'0
28%
13.575
17.675 (63%)
n.c.
n.c.
30.558
28.158
$16.983 (56%)
n.c." Not calculated
* Assumes
Without
Amendment
$4.1 billion in State tax reduction.
Source: U.S. Bureau of Census, Government Finances. and estimates by the author.
18
52 percent to 28 percent because of the amendment,34 placing California below all but six other
states in this regard. 35
Political theory suggests that the control of
public expenditure ultimately rests with the body
which is responsible for raising the revenue. If
this is correct, Proposition 13 will lead to a major
shift towards State control. The prohibition
against employee cost-of-living increases and
against reductions in public safety may be just
the tip of the iceberg for future state interventions. Local control or "home rule" could become a thing of the past in California. 36 Any
judgment here, however, must remain in the
realm of speculation. Our experience with Federal Revenue Sharing has shown that revenueraising and expenditure authority can at least
sometimes be kept separate.
Less uncertainty surrounds the tax-structure
consequences of Proposition 13, which tends to
substitute State tax sources for the local property
tax. More specifically, in the absence of this
measure, the State probably would have cut
income taxes.J7 Since the income tax tends to be
more progressive than the property tax, such a
substitution presumably would have favorable
equity consequences. 38
Again, given the fact that income-tax reduction was the major alternative to Jarvis-Gann,
areas which are relatively property intensive
should now gain relative to those areas which are
income intensive. Since cities and rural areas
have a larger share of the statewide property-tax
base than of the income-tax base, taxes consequently would be shifted towards the suburbs.
Given the poor fiscal condition of many central
cities, such a shift would provide welcome relief.
Further relief for fiscally disadvantaged jurisdictions should come from a little-noticed feature of the State relief measure, which allocates
relief roughly in proportion to previous
property-tax collections. 39 Because of the
massive reduction in property-tax receipts, it was
necessary to specify how the remaining revenues
from this source were to be allocated. Basically,
the State Legislature decided to allocate these
proceeds among counties in proportion to their
total assessed valuation. This precluded intercounty tax transfers. Within each county, however, tax proceeds were divided roughly in proportion to previous property-tax collections; i.e.,
each local unit suffered the same percentage
revenue loss. If this arrangement is continued,
therefore, future increases in assessable base will
be shared by all units within a jurisdiction.
In effect, California has developed a system of
tax-base sharing similar to that in operation in
the Minneapolis-St. Paul area, whereby increments to the metropolitan tax base are shared by
all local units within the urban area. (However,
the Twin City program is on a metropolitan
rather than county basis.) Base sharing has been
widely touted as a technique to cope with the
adverse fiscal consequences of suburbanization,
so that a central city does not suffer revenue
losses if its tax base moves to the suburbs. 40
Moreover, the city reaps part of the benefit of
whatever net growth occurs in the metropolitan
area. Perhaps unwittingly, therefore, California
with Proposition 13 has radically changed fiscal
relationships in its metropolitan areas. 41
In summary, the adoption of Proposition 13
may profoundly affect the system of governance
of California. On the one hand, it could lead to a
substantial loss in local control, while on the
other, it could significantly affect fiscal relationships within metropolitan areas. Finally, it
should increase the equity of California taxes,
among persons and among political jurisdictions.
IV. Summary and Conclusions
This paper has shown that the emergence of the
Jarvis-Gann Amendment cannot be attributable
to a single cause, but rather to several different
forces. First was a high and growing state-local
tax burden during a period when similar burdens
in other parts of the country were levelling off.
Second was a substantial shift in the distribution
of property-tax burdens towards homeowners at
a time when inflation was already causing budgetary problems for many households. Lastly
was the emergence of a significant State surplus
which, if left unchecked, would have grown to
unreasonable proportions.
Each of these factors contributed to the different perspectives which voters had of the measure.
By placing a ceiling on the property-tax rate,
19
restnctmg the growth of assessments, and
increasing the political majorities required for
new taxes, the amendment promised to restrict
the size and growth of the public sector. By
focusing tax reduction upon property. taxes, it
provided the relief sought by homeowners. And
finally, by placing local governments in an intolerable fiscal situation, it forced the State to
liquidate much of its surplus.
Proposition 13 apparently has achieved two of
its objectives-reduction of property taxes. and
liquidation of state surpluses-but to date it has
had only a minimal effect upon the growth of
public expenditures. In its first year, it required
only a 2.8-percent reduction in the average level
of public services; in the near future, barring a
major recession, it may have little effect unless
the State withholds the relief it can afford and
which it seems already committed to provide.
In effect, then, Proposition 13 emerges primarily as a tax-reform measure-one which
shifts the emphasis from the property tax to the
income tax. Moreover, by shifting a major portion of local revenue-raising responsibility to the
State, the amendment may seriously erode local
control. The measure has also had some unintended consequences for fiscal relations at the
local level, since the property taxes that remain
are to be shared on a county-wide basis. This will
tend to augment the resources of fiscally weak
governments at the expense of the more affluent.
These unintended consequences aside, Proposition 13 emerges as a unique California phenomenon. The combination of factors which
gave it birth are unlikely to be matched in any
other state. The same can be said of its consequences. The existence of a significant State
surplus has mitigated its potentially disruptive
impacts upon the delivery of public services. This
carries an important lesson for other states that
have been considering measures similar to
Proposition 13. Unless a considerable surplus
already exists somewhere in their state-local
system, they cannot expect to match the relatively smooth transition experienced by California.
Without such a surplus, their citizens and public
officials must be prepared to face considerable
disruptions in the flow of public services.
Appendix
Behavior of· Residential Investment
Let Vet) be the market value of a home whose
assessed value at t = (T-1978) = 0 is equal to k%
of its true market value. Furthermore, assume
homes appreciate at the constant rate g% per
year, so that
Vet) = V(O)(l
+ g/
= s(l
pet, u)
(l)
if
u=O
~
-1
A(t - I, u) = (1.02)
if u=O
u;:;::,
pet, u)A(t, u).
u=o
Morever, since
-1
pet - I, u) = (l - s) pet, u)
= (1.02)t-Uy(u)
(1.02)t kV(O)
d
if
I
(3)
t
Under Proposition 13, the assessed value of such
a home is equal to
f
\=
(1 -
u
The expected assessment of the home at time t
is given by
A(t)
A(t, u)
=
1
- sr
(2)
A(t, u)
(4)
(5)
(6)
we can express (4) as
A(t) = (1.02)(l - s)A(t - I)
+ sY(O)(l + g)t,
where u is the year of the last sale of the home.
Let the probability that a home is sold during a
given year be given by set), and assume. thats(t)=
s, for all 1. Then the probability that, at time t, the
house would have last been sold (t - u) periods
earlier is given by
(7)
which is a first-order linear differential equation.
Assume there are two classes of residential
property which differ only in their ratio of
assessed value to market value. The first class,
20
denoted by the subscript 1, has an initial assess~
ment ratio of 1, while the other, denoted by 2, has
an initial ratio of k. Then the expected aggregate
assessed value is
B(t) = [wA 1(t)
+ (1
- w)A 2 (t)] . N
lim
=g
B(t-I)
Moreover, it is easy to show that if the same
condition holds
t - oo
(8)
where w is the share of homes in class 1 and N is
the number of homes. For convenience we normalize so that N = 1.
Using (7), we can express (8) as
B(t) = (1.02) (1 - s)B(t - 1)
+ sV(O)(I + g/
which has the solution
B(t) = [B(O) - (~)]at
z-a
dt
Table A.1
State and Local Taxes
as a Percent of
Personal Income, 1957-78
(9)
+ (_b_)zt+l
z-a
= _---=:-1_ _
w + (1 - w)k
r
1957
1962
1963-64
1964-65
1965-66
1966-67
1967-68
1968-69
1969-70
1970-71
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
1977-78
1978-79
1978-79
(II)
(12)
where r is the aggregate assessment ratio at t = O.
Substituting from (11) and (12) into (10), and
setting t = 1, we obtain
B(l)
r
2
= - -1 a s asr z2 ]
[z(l - -) + -z
(13)
California
Other U.S.
Difference
(1)
Year
(10)
where
a = (1.02)(1 - s)
b = sV(O)
z = (1 + g)
Now let us normalize B such that
B(O) = wA 1 (0) + (1 - w)A 2 (0)
= wV(O) + (l - w)kV(O)
=1
Then
V(O)
B(t) - B(t - 1)
(2)
(1-2)
9.31
10.46
12.07
11.98
12.47
11.98
13.37
13.71
13.38
13.73
14.94
14.91
14.01
14.59
14.89
15.78c
15.96c
15.97 c
12.64d
8.14
9.32
10.13
10.24
10.43
10.32
10.49
10.91
11.44
11.66
12.42
12.71
12.16
12.00
12.17
12.38a
12.11 a
11.93 b
11.93b
1.17
1.14
1.94
1.74
2.04
1.66
2.88
2.80
1.96
2.07
2.52
2.20
1.85
2.59
2.72
3.40
3.85
4.04
0.71d
Source: U.S. Bureau of Census, Government Finances
a Based on U.S. Commerce Department estimates, reported
in Survey (}f Current BuSiness.
b Same as a, but first quarter 1978 used to project entire year.
Since we have set B(O) = 1, (11) represents one
plus the growth rate of the aggregate assessments
for the first year. Choosing s = .15, g = .1, and r =
.75, yields B( 1) = 1.087. With r =.74, B(1) = 1.09.
It remains to examine the subsequent growth
of B(t). Clearly, if 1 + g> (1 - s)( 1.02), which is to
be expected,
c 1976-78 tax receipts based on author's estimates using
California State Comptroller Repofts. Pefsonal income
for 1978 from Economic Report of the Governor, 1978.
d After Proposition 13.
21
Table A.2
Property Taxes as a
Percent of Personal Income,
1957-78
Year
Other U.S.
Difference
(1)
1957
1962
1963-64
1964-65
1965-66
1966-67
1967-68
1968-69
1969-70
California
(2)
(1-2)
4.39
5.61
6.04
5.93
6.26
6.16
6.19
6.33
6.27
3.61
4.17
4.41
4.43
4.44
4.28
4.21
4.26
4.36
.70
1.44
1.63
1.50
1.82
1.88
1.98
2.07
1.91
Year
California
Source: U.S. Bureau of Census, Government Finances
Difference
(1)
1970-71
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
1977-78
1978-79
Other U.S.
(2)
(1-2)
6.75
7.11
7.02
6.28
6.27
6.41
6.56a
6.44a
6.32a,c
4.49
4.65
4.58
4.30
4.25
4.29
4.18b
4.09b
3.97b
2.26
2.46
2.44
1.98
2.02
2.12
2.38
2.35
2.35
b Estimated using U.S. Commerce Dept. data.
c Without the passage of Proposition 13.
a Estimated using State of California data on property-tax
collections.
Table A.3
Distribution of Net* Assessed Value and Property Tax Burden
on Single-Family Dwellings in California,
1964-65 to 1978-79
Share of Total Net Assessed Value
Period
Single-Family
Other
NonResidences
Residences Residential
State
Assessedf
Share of
Property Taxes
of Single-Family
Dwellings
Taxes on Single-Family
Dwellings as a Percent
of Personal Income
(1)
1964-65
65-66
66-67
67-68
68-69 a
69-70b
70-71 c
71-72
72-73
73-74d
74-75e
75-76
76-77
77-78
78-79
(2)
(3)
(4)
(5)
(6)
34.8%
34.5
34.0
33.6
34.0
32.2
33.5
33.7
34.0
31.6
32.9
35.2
39.5
41.0
43.0
12.3%
12.6
13.3
13.7
13.8
14.4
14.8
14.5
13.9
13.8
13.4
13.2
12.9
12.6
12.6
40.8%
41.4
41.8
42.6
42.6
44.0
42.9
43.8
44.4
46.9
46.4
44.7
41.0
39.6
38.3
12.1%
11.5
10.9
10.1
9.7
9.5
8.8
8.1
7.6
7.7
7.3
6.9
6.6
6.7
6.4
36.2%
34.8
35.3
35.0
35.4
33.5
34.8
35.0
35.2
32.1
33.9
36.2
40.4
42.2
44.3
1.97%
2.01
2.04
2.05
2.11
1.98
2.24
2.37
2.35
1.88
1.98
2.16
2.48
2.53
2.60
*
Net of exemptions
First significant "~open space" assessments.
Introduction of $750 homestead exemption; 15-percent inventory exemption.
With 30-percent inventory exemption.
With $1,750 homestead exemption; 45-percent inventory exemption.
With 50-percent inventory exemption.
State-assessed property is mainly personal property of utilities. Beginning in 1964 and ending in 1974, the assessment ratio
on this class was lowered until it reached the ratio applying to other classes.
Source: California Board of Equalization; author's estimates for years 1975-76 to 1978-79.
a
b
c
d
e
f
22
FOOTNOTES
of taxes, it applies equally well to government expenditures because taxes and expenditure move together. An
exception to the latter occurs after the 1977-78 fiscal
year when substantial surpluses emerge. However, the
gap between tax burdens in California and the rest of
the U.S. had already opened substantially by 1977-78.
1. This rate limitation does not apply to the debt
service on outstanding debt.
2. This description of the Amendment is only meant to
be suggestive. For a more thorough discussion see the
Beebe article in this Review.
3. It is estimated that a levy of 1/4 percent would be
necessary initially to service outstanding debt.
17. Another element which may have played a role is
the Serrano decision on the finance of elementary and
secondary education. To implement Serrano, the State
had planned to redistribute property taxes from rich to
poor districts. Such action was to begin in the fiscal
year 1978-79, but because of Proposition 13's restriction on property tax receipts, it had to be tabled. One
might argue that support for Proposition 13 came from
those who saw the impending State action as eliminating the connection between their property tax payments and the level of educational services they received. It should be noted, however, that under the
State plan, local overrides to increase educational
expenditures were permitted. See Analysis of the Budget Bill, California State Legislature, Sacramento, 1978,
p.720.
4. "Analysis of the Fiscal Impact of the Proposed
Jarvis-Gann Amendment", Report to the Bureau of the
Budget to the Board of Supervisors, San Francisco,
March 1978. The unevenness of these cuts reflects the
fact that not all services are equally funded by the
property tax, as well as the existence of a myriad of
State and Federal mandates.
5. U.S. Bureau of the Census, Government Finances
in 1975-76.
6. This conjecture is rejected by the U.S. Congressional Budget Office, which using unpublished data
concludes that tax burdens in California have been
growing about the same rate as elsewhere. Curiously, a
67 percent difference in growth rates of tax burden is
interpreted as a 2.2 percent differential (Le., 5.5 percent
vs 3.3 percent). See "Proposition 13: Its Impact on the
Nation's Economy, Federal Revenues, and Federal
Expenditures", Congressional Budget Office, July
1978.
18. The localities also have control over a modest
General Relief Program. However, the amounts here
are too small to warrant explicit discussion.
19. "Recent National, Regional and International Developments", Federal Reserve Bank of San Francisco,
September 5, 1978.
7. U.S. Bureau of the Census, op. cit.
20. Legislative Analyst, "An Analysis of Proposition 13:
The Jarvis-Gann Property Tax Initiative", Sacramento,
May, 1978.
8. Ibid.
9. Ibid.
10. Since the homeowners' share of State personal
income is unknown it was not possible to construct an
index of homeowner tax burden per se. Nevertheless, if
income shares were constant over the period, the 30
percent figure is a measure of the increase in homeowner burden.
21. Since the California Board of Equalization makes
annual surveys of assessment ratios, one would have
expected such widespread underassessment to show
up in their data. However, figures for fiscal year 1977-78
only indicated underassessment of 8 percent in terms
of current prices. See Annual Report, State Board of
Equalization, 1976-77.
11. Real Estate Research Council of Northern California, Northern California's Real Estate Report, Vol.
30/Number 1.
22. Total assessments for 1978-79 were $116.2 billion
compared with the estimate of $108.1 billion. At a tax
rate of $5 per $100 valuation, the extra $8.1 billion would
yield $405 million.
12. This figure for 1975 is the latest year for which
national data is available. While the California number
for that year is close to the national average, the recent
upsurge in residential share in California is unlikely to
be matched nationally because the boom in real estate
prices was much more pronounced in California than
elsewhere. Advisory Commission on Intergovernmental Relations, Significant Features of Fiscal Federalism,
1976-77, Vol. II, p. 106.
23. Excluding Special Districts, for which data were
unavailable, non-property tax receipts grew as follows:
1974-75-1975-76-12.6%; 1975-76-1976-77-10.2%;
1976-77-1978-79-20.7%.
24. The 55 percent wage share was taken from Governmental Finances, op. cit., p. 30.
25. U. S. Bureau of the Census, Public Employment in
1976.
13. The term "at least" is used because the State's
projections, from which our figures were drawn, have
proved markedly conservative in the past.
26. A survey by the Los Angeles Times showed that
California cities increased expenditure by 4.6 percent
and counties by 5.3 percent over 1977-78 levels. By our
estimates such increases were sufficient to maintain
real 1977-78 spending levels. Los Angeles Times, October 1, 1978.
14. Economic Report of the Governor, 1978, Sacramento, 1978, p. A-55.
15. To arrive at this figure, multiply the 11 percent by
1.7 to obtain the growth of Personal Income Tax
receipts.-18.T percent. Since the latter accounts for 1/3
of total general revenue, the growth of total revenue is
simply (1/3 X 18.7) + (2/3 x 11.m = 13.5.
16. Although our argument has been couched in terms
27. The City Auditor is quoted as saying that the City
"would probably have a surplus of $51 million", San
Francisco Chronicle, September 6, 1978.
23
were not available at the time this paper was written.
28. The situation with the San Francisco 'Unified
School District is similar. The budget for 1978-79 actually appears to be higher than for the preceding year.
35. Advisory Commission on Intergovernmental Relations, op. cit.
29. Legislative Analyst, op. cit.
36. This home-rule effect of Proposition 13 is reinforced by the Serrano school finance decision, which
requires greater uniformity of expenditures among
school districts.
30. Of course, because of the progressivity of the
income tax, effective rates increase.
31. This assumes locally raised revenue also grows at
without-Amendment rates. Otherwise, the 2 percentage points is added to the gap left by the latter revenues.
See below.
37. While any of the major State taxes could, in principle, be cut, the California Legislature has cut income
taxes three times in the past decade. It seems reasonable, therefore, to view income taxes as the marginal
instrument.
32. Study by San Mateo County Manager, May 8,1978.
While one would expect turnover rates to be reduced
somewhat because reassessment is triggered by transfer, the effect is likely to be small. Most property transfers involve employment transfers, reti rement, or death.
Moreover, the maximum savings from maintaining
ownership is 1 percent of the value of the home-a
figure which may be small compared to the benefits of
upgrading one's housing.
38. Recently, it has been argued that the incidence of
the property tax rests upon the owners of capital.
However, this outcome is based upon the premise of a
nationally applicable property tax. Since the case at
hand is restricted to a single state, its major consequences will be upon output and input prices, as the
orthodox theory would predict.
33. To arrive at this figure the shortfall in relief growth
of 2 percentage points must be translated into a fraction
of total local revenue. This is done by observing that
State relief is 70 percent of the size of local property tax
receipts. Hence, the shortfall in State relief is equivalent
to a 1.4 percentage point shortfall in property tax
receipts. Since property taxes constitute 20 percent of
local revenues, we have a revenue shortfall of .28
percent because of State relief. The latter is then added
to the reassessment result and rounded.
39. An exception is with aid to education. Here relief
was allocated according to a complex formula which
reflected an attempt to equalize resources between
school districts. See SB 154, California State Legislature, 1978.
40. Unless the suburb was located in another county.
Note that city-counties such as San Francisco obtain
no benefit from this provision.
41. Si nce the relief measu re is for the fi rst year on Iy, it is
conceivable that the State Legislature might change the
distribution formula in future relief measures. For example, county property tax revenues could be divided
among local units in proportion to a unit's share of
aggregate assessments. Because the jurisdictional
boundaries of many local units overlap, however, such
an approach might produce nonsensical results. Moreover, if the objective of the relief was to minimize
disruption of public service flows, the present allocation formula may be optimal.
34. There is some reason to believe, however, that the
figures in Table 7 may overstate the effects of the
Amendment on education finance. In response to the
Serrano decision the State had decided to redistribute
property tax receipts among local school districts beginning with fiscal year 1978-79. Because of the limitation on the level of property taxes imposed by JarvisGann, this action had to be shelved. Strictly speaking
those funds which were to be redistributed should be
counted as State as opposed to local funds. Unfortunately, estimates of the extent of such redistribution
24
Jack H. Beebe*
California is at the forefront of a conservative
wave throughout the country to limit the size of
government. Although California is somewhat
unique in that its voters' efforts so far have been
directed mostly at reducing property taxes, nationwide grassroots efforts to restrict government spending and taxes have since gained
momentum in at least half of the 50 states.
Like many states, California has an initiative
process by which voters can petition to place
constitutional amendments directiy on the state
ballot. When the Assembly failed to enact property tax relief in 1977, a number of tax protestors began to circulate tax-limitation petitions,
with most of them uniting behind a proposal
developed by Howard larvis and Paul Gann
which called for a dramatic decrease in (and a
permanent restriction on) property taxes. By
December 29, 1977, the Jarvis-Gann Amendment had gained the needed signatures to qualify
as Proposition 13 on the lune 1978 state-primary
ballot. On lune 6, the measure passed by an
overwhelming 2-to-l majority.
Proposition I3 restricts revenue sources, and
hence, decreases the expected future income
stream of local governments and special districts
in California. It also restricts increases in the
state's taxing powers, thereby blocking large
increases in state taxes as an alternative source of
government revenue. Since such restrictions
should ,affect the ability of municipalities Ito
serviCe and retire debt, Proposition 13's passage
may adversely affect both the cost of new issues
and the value of existing California municipal
debt.
Proposition 13 and similar measures that are
now sweeping the country may have an important impact on the cost and value of municipal
debt. Hence, they have important implications
for present and potential holders of municipal
debt, for policymakers at all levels of government, and for voters who wish to consider
possible side effects of alternative ways to reduce
the size of government. This article shows that
Proposition 13 affects particular kinds of municipal debt in different ways because of the specific
wording of the amendment. For example, debt
secured solely by property-tax revenues is severely affected, while other kinds of debt backed by
general tax revenues are affected less or not at all.
It is concluded, therefore, that restrictions on the
size of government need not have dramatic
effects on the cost or value of government debt.
However, if such restrictions are applied only to
certain sources of revenue, they may have large
and unintended side effects.
This study examines what has happened to
new-issue interest costs for different categories of
California municipal bonds since Proposition 13
was placed on the ballot at the end of 1977. Data
rarely exist for secondary-market yields because
of the thinness of the market, so the interest cost
for new issues is used here to represent the yield
on existing debt. In this manner, the study also
provides estimates of the effects of Proposition
13 on the value of outstanding debt. In Section I,
Proposition 13 is described and hypotheses are
presented concerning its effects on each category
of bond. In Section II an econometric model is
developed to explain statistically the interest cost
of new issues. The model is estimated for each
category of bond, and an estimate is obtained for
the overall effect of Proposition 13 as well as for
the individual effects of changes in bond ratings
and other explanatory factors. In Section III,
inferences are drawn regarding the adverse effects on the value of outstanding California
municipal debt. In the final section the summary
and conclusions are presented.
*Assistant
Vice President and Economist. Federal Reserve
Bank of San Francisco, Pat Weber provided research assistance for this paper.
25
I. Probable Effects of Proposition 13 on California Municipal Debt
Factors that affect default risk vary widely for
municipal bonds, depending principally on each
bond's security-that is, the legal and economic
constraints affecting the cash flow available for
debt service and retirement. At one extreme, a
pure revenue bond is secured solely by the
revenue generated from the financed project,
such as a parking lot. For such a bond, the cash
flow of the project, and hence the security of the
bond, is completely independent of the cash flow
of the issuing municipality. Thus, the risk of the
bond depends solely on the risk of the project,
and not on the general condition of the government. At the other extreme, a general-obligation
bond is secured by the general cash flow of the
issuing government, and thus is not tied to a
specific project or revenue source. Thus, risk of a
general-obligation bond depends on the solvency
of the issuing government.
There are many variations of municipal
bonds, as we see below. In analyzing the risk of a
particular bond, one looks first at the legal
provisions for the bond's repayment and second
at the economic prospects involved. Since Proposition 13 reduces revenues from property taxes
and generally attempts to restrict tax increases at
the state-and-local level, it should affect debt
whose security is limited principally to propertytax revenue. It might also affect debt whose
security depends on the overall cash flow of the
state and local governments. For these reasons,
we need to consider the legal provisions of
Proposition 13, and then its possible consequences for various kinds of municipal debt. 2
However, properties sold, traded, or newly constructed after 1975-76 may be reassessed at
current market values.
Proposition 13 also attempts to prevent other
taxes from rising to offset the lost property-tax
revenues. First, it requires that State-tax increases be passed by a two-thirds vote of all
members (not just those voting) of both houses
of the legislature. Second, it states that property
taxes cannot be raised beyond the above limits
(even by voter approval), and that other local tax
increases must gain the approval of two-thirds of
all "qualified electors"4 in the affected municipality.
Proposition 13 specifically exempts tax increases needed to service prior voter-approved
debt: "The limitation...shall not apply to ad
valorem taxes or special assessments to pay
interest and redemption charges on any indebtedness approved by the voters prior to the time
this section becomes effective." For this reason,
payments on debt approved by voters prior to
the effective date of Proposition 13 are not
subject to the specific tax constraints placed on
property. But payments on all new debt approved after that date, and on all prior debt not
voter-approved, would be constrained by the
tax-limitation provisions of the amendment.
From its first introduction until the June 6
election, Proposition 13's effects on the cost of
municipal debt were a function of the probability
of passage. Throughout much of the pre-election
period, poll results indicated probable passage.
However, the landslide victory was not apparent
Proposition 13
Proposition 13 rolls back current taxes-both
tax rates and assessed values-on all property to
I percent of 1975-76 market value. (State budget
analysts originally estimated that this would
mean an initial $7-billion, or 57-percent, reduction in California property taxes--one-third
attributable to owner-occupied homes and the
rest to rental, non-residential, and personal
properties, as well as inventories.)3 Tax rates
must then be held at the I-percent ceiling, while
assessed market values may rise no more than the
annual percentage increase in the consumer price
index or 2 percent per year, whichever is less.
Table 1
Poll Results Through
the Pre-Election Period
Proposition Feb Mar27- May May
11-23 Apr 3 1-8 29-31
13
June 6
Election
Results
Yes
20%
27%
42%
57%
65%
No
10
25
39
34
35
70
48
19
9
Undecided
Unaware
Sources: Field Institute surveys as reported in the San Francisco Chronicle, June 2. 1978. Election results as
reported in the California Journal. July 1978.
26
until the last several weeks before the election,
when voters rallied behind the strong message
that Proposition 13 carried to all levels of government (Table I).
credit" or "unlimited tax" bonds, are normally
issued by state or local governments only with
prior voter approval. Debt service for G.O.'s
may be paid out of any available revenue source,
with the issuing authority pledging its full faith
and credit to meet such payments.
Effects on types of debtS
Proposition 13's effects on the municipalbond market depend very much on the security
of each type of bond, as is seen below. In this
paper, State bonds are described because of their
importance, but they are omitted from the empirical tests because only a few such bonds were
issued during the sample period. 6 To aid the
reader, Table 2 provides a summary of the
hypothesized effects for the various types of
bonds.
Despite the emergence of Proposition 13 and
the reduction of the large state-budget surplus,
the State of California throughout 1978 was
rated AAA by Standard and Poor's (S&P) and
Aaa by Moody's, owing largely to the state
government's fiscal conservatism and a rapidly
growing tax base. Proposition 13 conceivably
might have jeopardized the state's strong credit
rating, for several reasons: (I) a drawdown of the
state surplus and an increase in state expenditures was required to assist local governments;
(2) increases in state tax rates henceforth will
require two-thirds favorable vote of both Houses
of the legislature; (3) state debt might be increased to finance public-works projects that
otherwise would have been financed by local
G.O. issues, and (4) analysts may have believed
that Proposition 13 would have a depressing
effect on the state economy.
General-obligation bonds (state and local)
G.O. Bonds, also known as "full faith and
Table 2
Hypothesized Effects of
Proposition 13 on
California Municipal Debt
State General
Obligations
Aaa rating would be jeopardized at least
in transition period. Longer-term effect
depends on whether expenditures are
reduced sufficiently.
Local General
Obligations
Existing I debt not affected because of its
exemption from revenue ceiling. New
debt adversely affected unless authorized
under a non-ad-valorem special tax.
State and Local
Revcnue
No effect on new or existing "pure'"
revenue bonds. which constitute the majority of revenue bonds. Small negative
effect on hybrid bonds with tax revenue
as backup security.
Local Tax
Allocation
Severe negative impact on new and existing debt due to restrictions on property
tax assessments and rates.
Local LeasePurchase
Negative effect on non-voter approved
existing debt and on new debt because of
local government's increased difficulty in
meeting lease payments. Extent of effect
highly variable depending on whether
facility is "essential" and whether it could
generate sufficient revenue to sustain
debt service if local government failed to
meet lease payments.
I
Over the near term, it is possible that Proposition 13 would have no adverse effect on the safety
of state G.O. bonds, despite the expenses incurred as the state strives to help out local
governments. Although a two-thirds vote of the
legislature would permit additional taxes to pay
off debt, such use of revenues would represent
one of many demands for funds. Over the longer
term, the effect on state debt would depend
largely on how the state elects to run its fiscal
operation in response to local-government needs
on the one hand and to voter pressures for fiscal
conservatism on the other.
Because Proposition 13 singles out ad valorem
(property) taxes, local G.O. debt would be affected somewhat differently from state G.O. debt.
For "existing" voter-approved bonds (those
which received voter approval prior to July I,
1978, regardless of when they were actually
issued), debt service would be exempted from the
I-percent tax-rate ceiling imposed on ad valorem
taxes. Thus, property-tax overrides could be
employed without special voter approval to meet
the payments on "existing" voter-approved debt.
"Existing'" debt comprises bonds that were approved prior
to July I. 1978. while "new'" debt comprises issues approved July I and thereafter.
27
However, "new" G.O. debt (that approved by
voters July I or thereafter) would have to be paid
from available revenues as constrained by Proposition 13. (Any extra tax revenues would have
to be passed by a two-thirds vote of "qualified
electors," and even then, new taxes could not be
levied on property.) As a result of these specific
provisions, there should be no significant effect
on "existing" local G.O. bonds, but there should
be some adverse effect on "new" local G.O. debt.7
approved. Property-tax revenues generated by
the fixed base-year assessed value are allocated
to existing tax bodies such as a city or county.
Then, additional tax revenues from the increase
in assessed value over the fixed base-year levt.(lthe tax-increment revenues-are allocated to the
redevelopment agency. They are used to payoff
debt of the agency and to provide internal funds
for further project expansion. Redevelopment
agencies have commonly used long-term debt to
finance improvements that are sold at less than
cost. The tax-increment revenues are then used
to payoff the debt, and in this manner, they
indirectly provide for a subsidy on improvements.
Because it lowers assessed values and
property-tax rates, Proposition 13 seriously affects the revenue base for tax-allocation bonds. 10
And because of the heavy debt service of many
redevelopment districts, II such a severe restriction on revenue could easily result in default in
many cases. Increased default risk should result
in an increase in interest cost for new issues and a
decline in the market value of outstanding
bonds.
Revenue bonds (state and local)
Revenue bonds are normally issued to finance
revenue-producing facilities, and user fees are
generally pledged to pay the debt service. They
may be issued by municipalities or special districts (such as sewer or hospital districts). The
repayment of "pure" revenue bonds does not
depend on the operating budget of the municipality.s Thus, Proposition 13 would presumably
have no effect on either state or local "pure"
revenue bonds.
In some cases, municipalities pledge general
(property) tax revenues as backup security in the
event that user fees prove inadequate to cover the
debt service. In these cases, Proposition 13
would jeopardize the quality of the backup
security. Furthermore, revenue bonds are now
sometimes used to finance the cost of selfinsurance plans such as workers'-compensation
and medical-malpractice insurance. Not being
tied to a revenue-producing facility, these bonds
must be secured by the available revenues of the
municipality involved. Despite such exceptions,
revenue bonds normally are secured by the
revenues of the facility rather than by property
taxes or general tax revenues ofthe municipality.
Thus, for revenue bonds in the aggregate, Proposition 13 should have little or no effect on interest
cost.
Lease-purchase bonds
These bonds, also called lease-revenue or
lease-rental bonds, are issued by a public, private
or nonprofit leaseback corporation which uses
the proceeds to construct some facility that is
then leased to a municipal government. The
municipal government (lessee) makes rental payments to the corporation (lessor) sufficient to
pay debt service on the bonds and operating
expenses of the corporation. In general, such
obligations are not voter approved, and the
municipality normally promises to provide for
rental payments out of its operating budget.
Lease-purchase bonds are sometimes revenuesupported to the extent that the facility's revenues provide for the debt service. As with reve-
Tax-allocation bonds
These "limited tax" bonds are used extensively
nue bonds, Proposition 13's impact depends
to finance redevelopment projects throughout
California, but are not in wide use outside the
State. They are financed and secured primarily
by the "tax increment" revenues on a specific
redevelopment project.9 Under tax-increment
financing, property values prior to the project
are "fixed" in the year during which the project is
largely on the ability of the project, such as a
parking lot, to be self-supporting in the event
that the municipality reneges on its lease contract. However, many lease-purchase bonds are
supported solely by lease payments from the
municipality's operating budget. These will be
negatively affected to the degree that the munici-
28
pality’s financial condition deteriorates and tax
payers regard the facility to be a non-essential
service. Thus, the safety of lease-purchase bonds
might decline somewhat under Proposition 13,
because the municipalities might lack flexibility
to meet payments within their budgets and
taxpayers might regard continued lease pay
ments as a non-essential expenditure.
\ l Empirical
The previous discussion suggests that Proposi
tion 13 should have affected the interest cost of
some types of new issues as the election results
grew more certain. The effects can be measured
by an examination of data on new issues of local
municipal debt in California sold between Janu
ary 1, 1977, and October 3, 19781 —and specifi
2
cally by an analysis of the average yield spread
between new California issues and Moody’s Aaa
new-issue index. The time period is divided into
three subperiods: all of 1977 (pre-Proposition
13); January 1-June 6, 1978 (the period of
Proposition 13’s increasingly likely victory); and
June 7-October 3, 1978 (post-Proposition 13).
Over the first half of 1978, and possibly begin
ning as early as December, 1977, interest spreads
clearly increased for tax-allocation, leasepurchase, and possibly for revenue bonds (Chart
Ewidence
1). By the time of the election, the interest cost on
tax-allocation bonds was almost 300 basis points
above the Moody’s Aaa rate, compared with an
average of roughly 50 basis points in 1977. More
important, there were no new tax-allocation
issues after the election.1
3
Chart 1 gives an informative, albeit simplistic,
picture of Proposition 13’s effect on the cost of
California debt. In the remainder of this section,
statistical models are used to obtain refined
measures of the amendment’s effect on each kind
of bond. In the process, it will be possible to
quantify the extent to which Proposition-13related increases in new-issue interest cost have
been associated with changes in bond ratings,
number of bids per issue, and other factors that
normally help to explain the interest cost.
1
Spread Between California and National New - Issue Rates1
January 1977 - September 1978
Basis Points
1977
1978
1 California rates are equally-weighted averages of new-issue rates in each month. National rates are
the monthly averages of Moody's weekly Aaa new issue municipal bond index.
2 Date at which Proposition 13 was placed on the ballot.
3 Date at which Proposition 13 passed.
29
Interest-cost model
According to earlier statistical studies, the
most important factors explaining the interest
cost of new issues of a given category of bond are
the average level of municipal-bond yields nationwide, and factors specific to new issues such
as quality rating, size. of issue, number of competitive bids, and type of placement. 14 (The
alternatives to competitive bidding are negotiated sale or private placement.) A regression relatingall of these variables to new-issue interest cost
explains a significant portion of the variation in
interest cost from issue to issue.
Theoretically, the effects of Proposition 13
may have been transmitted through two distinct
channels. First, the amendment may have influenced ratings, bids, and other characteristics,
thereby leading to a rise in interest cost. Second,
it may also have directly increased the interest
cost of new issues without necessarily changing
these other characteristics. These alternative
channels can be sorted out by fitting different
models to the data. The alternative models
developed in this section will enable us to distinguish between the different possible channels of
influence.
For a typical period, such as the preProposition 13 period, a model of thefollowing
specification can be used to explain the interest
cost for new issues of California bonds:
Aa
A
(Baa-B)
LSIZE
LBIDS
The variable TERMST represents the national interest rate on a typical municipal bond of
high quality and comparable maturity during the
week that the new issue is sold. For the jth newissue, the value of TERMST can be calculated
according to the formula:
In MATj
.
.
.
TERMSTj = lit + (130t - lid In 30
where i l t = yield on Salomon Brothers index
for prime one-year general obligation municipal bonds during the
week that the jth issue is sold;
130t =:e,yield on Salomon Brothers index
for prime general obligation municipal bonds of 30-year maturity;
MATj=average maturity of the jth issue. 17
This specification of interest cost captures the
desirable logarithmic shape of a term-structure
model. In particular, it not only allows the entire
term structure to shift up and down, but also
allows the term structure to twist as short- and
long-term rates change relative to one another. 18
TERMSTj is then a single interest rate taken
from the term structure for week t and maturity,
MATj. An hypothesis on the coefficient, bl' of
TERMST is that b I = I, so that NIC rises and
falls with TERMST. 19 For some serial issues in
the following analysis, TERMST cannot be used
NIC = a + b l TERMST + d l DTERMST +
d2 Aaa + d3 Aa + d4 A + ds(Baa-B) +
b2 LSIZE + b3 LBIDS + d6 NEGOT
(I)
where
NIC
TERMST
DTERMST
Aaa
= zero-one dummy variable
equal to one for Moody's Aa
(S&P AA ) rating;
= zero-one dummy variable
equal to one for Moody's A
(S&P A) rating;
= zero-one dummy variable
equal to one for Moody's Baa
to B (S&P BAA to B) rating
(no bonds were rated below B;
nonrated bonds are the omitted
class);
= natural logarithm of the size of
the total serial issue in thousands ofdollars;
= natural logarithm of the number of bids received in competitive bidding;
= dummy variable equal to zero
for competitive bidding and
equal to one for negotiated sale
or private placement.
= "net interest cost" (interest
rate) for the new issue;15
= variable reflecting the nationwide interest rate for bonds of
high quality and comparable
maturity (see explanation below);
= dummy variable used when the
average maturity of the new
issue is unknown (see explanation below);
= zero-one dummy variable
equal to one for Moody's Aaa
(S&P AAA) rating; 16
30
significant effect on interest cost distinct from
that felt through the other variables. It is reasonable to hypothesize that as the amendment's
prospects became increasingly strong with the
approach of the election (Table 1), its effect on
interest cost would have increased. Then, the
certainty after June 6 should have had a constant
effect.
Given data limitations, it is best to hypothesize a linear trend for the pre-election 1978
period. In addition, a linear trend for 1977 and
an intercept shift for the first week in January,
1978, are introduced to test whether or not the
shift in 1977 was zero as hypothesized, and
whether there was any intercept shift in 1978.
The full model with structural time shift now
becomes (see Chart 2):
because it requires information on average maturity, which is not available from published
sources. To compensate for this, the regression
sets TERMST equal to i lt and adds another
variable DTERMST, equal to (i 30t -i lt ). 20
The following hypotheses suggest how the
other variables would affect interest cost. The
rating variables measure the increase in interest
cost over that of a comparable non-rated bond.
The higher the quality rating, the lower the
expected interest cost. Thus, the rating coefficients should have negative signs, although it is
not clear that a rating of (Baa-B) would carry a
lower interest cost than no rating. The effect of
issue size is ambiguous. Bond traders state that
both very small and very large issues pay a
premium-small issues because of a tendency for
underwriters to bid high due to the small potential payoff from obtaining detailed information,
and large issues because of "supply effects," that
is, the difficulty of reselling a large number of
bonds in large serial issues in a short span of
time. It is normally hypothesized that the number of bids reflects the degree of competition in
underwriting and the importance of imperfect
information (Kessel [11 ]). Interest cost should be
higher the fewer the bids under competitive
bidding, and should be higher still under negotiated sale or private placement.
NIC = a + b I TERMST + d l DTERMST +
"d2Aaa + d3Aa + d 4 A + ds (Baa-B) +
b2LSIZE + b 3LBIDS + d 6 NEGOT +
b 4 WEEK77 + d7DJAN78 +
b sWEEK78 + d g DJUN78
(2)
where
WEEK77 = linear time trend for the weeks in
1977;
DJAN78 = intercept shift dummy, dated January 1, 1978 (week 53);
WEEK * 8= linear time trend. for the period
January I-June 6, 1978 (weeks 53-'
Adding time shifts
Aside from Proposition 13's effects on ratings
and other variables, it probably also has had a
74);
DJUN78 = intercept shift dummy, dated June
6, 1978 (week 75).
The hypothesized signs for the effects on each
type of bond are:
Chart 2
Model for Structural Shift
in Interest Cost
General
Obligation
WEEK77
DJAN78
WEEK78
DJUN78
Jan. 1
1977
June 6
Revenue
0
0
0
0"
0
0
0
0
Tax
Allocation
Lease
Purchase
0
lJ
0
0
+
+
+
+
Because ratings and other issue descriptors
might have been affected by Proposition/I 3,
equation (2) should also be estimated with righthand variables that are not subject to possible
endogeneity. For this purpose, the following
model serves as an alternate measure of Proposition 13's effects:
Time
1978
31
NIC = a + blTERMST + dlDTERMST
b4 WEEK77 +d7 DJAN78 +
bsWEEK78 + dgDJUN78
+
Regression results26
General-obligation bonds. Although no
Proposition-13 effects were hypothesized for
G.O. bonds, the results in Table 3 suggest that
there might have been a slight impact prior to the
June election. (Chart 1 suggests the same result,
with some increase in rates in the month of May.)
Equation (2) in Table 3 shows a significant
downward shift in interest cost in Januaryl978
of 38 basis points, and an insignificant increase
of 1.6 basis points per week until the June
election. When ratings and other descriptors are
excluded (equation (3», the time effects and the
t-statistics are larger. However, the net effect of
the 57 basis-point decline in January and the 3.5
basis-point rise per week thereafter was still only
20 basis points by the time of the election,27
These effects may have been the result of Proposition 13, but they appear to have been small and
short-lived. As yet, there has been no postelection effect on general-obligation issues. 28
Revenue bonds. These bonds experienced a
significant downward drift in interest cost of 1.1
basis points per week in 1977. This unexplainable anomaly appears to be unrelated to Proposition 13 and to have ended well before the end of
1977 (see Chart 1). Otherwise there were no
significant time-shift effects,with the exception
of a significant upward shift of 71 basis points in
equation (3) at the time of the June 6 election.
There was also an upward shift in June using
equation (2), although it was smaller and insignificant. Detailed examination of the residuals
and of\the underlying data suggests that the
mark~t\ began distinguishing "pure" revenue
bondS from those of a hybrid nature (as discussed earlier), and that higher rates on some
hybrid bonds in the sample may have resulted in
a post-election upward shift of perhaps 70 basis
points. 29 However, without more data and greater detail on each issue, this result cannot be
demonstrated rigorously.
Tax-allocation bonds. The time shifts for taxallocation bonds are large and highly significant.
Interest costs rose at a rate of 13.5 to 14.2 basis
points per week over the early 1978 period. They
were 263 to 308 basis points higher by the week of
the election as a result of the amendment. However, because of the unexpected negative coefficient on the term-structure variable, TER MST,
(3)
This equation would attribute entirely to
Proposition 13 those changes in 1978 net interest
cost which are not related to changes in openmarket rates. Equation (3) would essentially
estimate the time-shifts apparent in Chart 1.
Changes in issue descriptors
Although ratings, size of issue, number of
bids, and type of offering cannot be considered
exogenous to Proposition 13 on a priori
grounds, in fact, significant shifts in values were
found ex post only for tax-allocation bonds.
Between 1977 and 1978, there were no significant
shifts in ratings for general-obligation, revenue,
and lease-purchase bonds, but there were shifts
for tax-allocation bonds significant at the 5percent level. 23 The following distribution of
ratings for tax-allocation bonds indicates that
the ratings deteriorated.
1977
Aaa
Aa
A
Baa-B
Not Rated
1978
Number Percent
3
6%
Number Percent
2
4
o
o
14
15
18
27
29
34
3*
15
17
0%
0
9
43
48
*Two in January and one on March 6.
On April 11, 1978, Moody's suspended its
ratings on all previously-rated California taxallocation bonds (64 outstanding issues, of which
31 had been rated A and 33 Baa or Baa-l).24
During the same week, Standard and Poor's said
that, in the event of Proposition 13's passage, it
would assess the impact on existing ratings of all
California bonds. 25
There was also a significant shift to fewer bids
and to larger size per issue for tax-allocation
bonds, but no significant changes for other categories. As the June 6 election approached, taxallocation issues generally received only one bid,
and during the six weeks immediately prior to
that date, several issues received no bids and
were retracted. Since June 6, no tax allocation
bonds have been issued.
32
Table 3
Regressions for Net Interest Cost
General Obligation
Eq. (2)
CONSTANT
TERMST
DTERMST
Aaa
Eq. (3)
.00
(.00)
.66
(1.09)
1.19
( 1.71)*
(-.05)
.87
(.09)2
.99
.86
(.10)2
Revenue
Eq. (2)
Tax Allocation
Eq. (3)
Eq. (2)
Lease-Purchase
Eq. (3)
1.71
(2.67)*
1.27
( 1.80)*
6.46
(7.15)*
.94
(-.50)
.92
(-.60)
(-7.06)*
(--6.40)*
-.40
(.14)2
.35
(.16)2
.74
(.11)2
.79
(.13)2
-.97
~.341
7.34
(7.83)*
~·.251
Eq. (2)
Eq. (3)
2.32
( 1.67)*
2.17
(1.29)
.74
(-.96)
.66
(-1.01)
.58
(.23)2
-.60
(3.25)*
(-2.32)*
-.22'
(-.59)
-1.39
(-4.77)*
Aa
-53
(-3.00)*
-.27
(-1.22)
-054
(-.11)
-1.34
(-4,69)*
A
-.48
(-5.15)*
-.19
(-1.14)
-.37
(-1.82)*
-.99
(-4.32)*
-.25
(-1.41)
.78
(.28)2
-.51
(-2.18)*
Baa-B
-.01
(-.13)
.12
(.65)
LSIZE
.026
(.93)
-.028
(-.71)
.250
(4.53)*
.062
(.97)
LBIDS
-.14
(-2.62)*
-.16
(-1.87)*
-.44
(4.02)*
.11
(-.87)
.28
(.96)
.10
(.17)
.18
(.67)
NEGOT
WEEK77
-.000
(-.08)
.001
(.27)
-.011
(-2.36)*
.011
1.97)*
( 1.40)
-.006
(-.97)
.007
( 1.42)
.007
(1.20)
-.34
(-1.05)
-.04
(.10)
-.39
('--1.60)
.77
(-2.47)*
DJAN78
-.38
(-2.18)*
-.57
(-2.81)*
.28
(.98)
.31
(.98)
WEEK78
.016
(1.52)
.035
(2.89)*
.001
(.02)
-.009
(-.37)
DJUN78
-.19
1.22)
.43
(1.26)
-.008
.71
( 1.85)*
R-Squared
Standard Error
Number of Observations
(Total)
(Jan-June 6, 1978)
(June 7-Sept 1978)
-.20
(-1.12)
.135
(7.58)*
.142
(7.00)*
.037
(2.01)*
.083
(3.61)*
.344
(.92)
-.33 4
(-.69)
.56
.42
.40
.50
.70
.35
.59
.42
.79
.57
.71
.67
.66
.40
.40
.53
158
48
22
158
48
22
58
II
13
58
II
13
88
35
0
88
35
0
63
19
2
63
19
2
* Significant at the 5 percent level for one-tailed test. Numbers in parentheses are t-statistics against a nul! hypothesis of zero
except for the coefficient of TERMST for which the nul! hypothesis is one.
4 Estimated based on only two observations.
I t-statistics for TERMST against Ho:O are
1.30 and -1.81 respectively.
For DTERMST, the figure in parenthesis is the standard error.
Insufficient data for estimation.
Estimate based on only three observations.
,
33
the time shift may be overstated. 30 Adjusting for
the contradictory term-structure relationship, it
is reasonable to conclude that the effect on tax
allocation bonds was at least 250 basis points by
the time of election. Indeed, this figure may be
highly conservative, because (I) several issues
were retracted when unsold prior to the election;
(2) other issues probably carried high yields, but
were not reported in the Bond Buyer because
they were sold through negotiation or private
placement; and (3) no new issues have come to
market since the election.
Lease-purchase bonds. As hypothesized,
lease-purchase bonds were also adversely affected by Proposition 13. In equation (2), the timeshift accounted for a 43 to 81 basis-point increase
in interest cost by the time of the election,
depending on whether or not the insignificant
dummy for January 1978 is included. In equation (3), the pre-election shift amounted to 106
basis points. A comparison of the coefficients in
equations (2) and (3) indicates that some of
Proposition 13's effect was experienced through
changes in ratings, despite the fact that the tests
described earlier did not find any such rating
change. The large negative coefficients for higher
ratings in equation (2) would help to explain a
rise in net interest cost even with a minor downgrading of ratings. Since the election, there have
been only two lease-purchase issues (rated A-I
and A by Moody's), and net interest costs have
declined from their peak in May 1978 (see Chart
I). According to one bond trader, rates on these
issues should decline further because most cityand-county governments have been able to adjust more smoothly to Proposition 13 than was
initially thought possible. Overall, the rate on
lease-purchase bonds was affected by more than
75 basis points by the time of the election, with
some subsequent decline.
much of the change in net interest cost was
channeled through the 1978 time-shift parametersand how much was channeled through
changes in ratings and other descriptors.
The change in net interest cost for generalobligation bonds, which is only 16 basis points,
can be related to term-structure variables. The
change for revenue bonds is greater (79 basis
points) and is matched by a 1978 time shift
almost as great. The rise in interest cost for taxallocation bonds (262 basis points) is more than
explained by the combined 286 basis-point effect
of 1978 time shift and changes in ratings, issue
size, and number of bids. Of the 139 basis-point
rise for lease-purchase bonds, 49 basis points
were felt through the 1978 time shift and 15
Table 4
Shift in Mean of Dependent
Variable Attributable to Changes
in Right-Hand Variables Between
1977 and Post-Election 1 Period
(Expressed in basis points)
General
Tax
LeaseObligation Revenue Allocation Purchase
Net Interest Cost
Change in Actual
Means
Change in Means
of Estimates
16
79
262
139
15
81
255
120
33
-36
73
-10
-21
235
8
'43 4
39
15
49
15
2
Right-Hand Variables
20
Term Structure
Time Shift 19772
0
-22
Time Shift 19783
Ratings
9
8
Other Descriptors
I
Channels of effects
The effects of Proposition 13 can be quantified
further by using equation (2) in Table 3 to trace
through the various channels that account for
the change in net interest cost between 1977 and
the "post-election" period. 3l Table 4 decomposes
the shifts in net interest cost for each bond
category into those related to changes in righthand variables. It does not tell us which channels
are statistically significant, but indicates how
3
4
I
10
For general obligation and revenue bonds. the postelection period is used (i.e., all issues after June 6). Because
there were no issues of tax allocation bonds and only 2
issues of lease-purchase bonds in the post-election period,
all issues after May I, 1978, were used as the "postelection" period for these categories.
Effect of WEEK77 only.
Combined effects of intercept shift variables and
WEEK78.
Larger issue size accounts for 20 basis points and fewer
bids per issue for 23 basis points.
Source: Calculated using estimates for equation (2) in Table
3 and means of right-hand variables for the two subperiods. In order for the components to sum to
totals, both significant and insignificant variables
were included.
34
through changes in ratings. 32 Altogether,
changes in ratings accounted for only a small
portion of the increase in net interest cost for
those bonds significantly affected.
III. Implications .for the Value of Outstanding Debt
lease-purchase bonds. It should be stressed,
however, that (1) the effect (if any) on revenue
bonds is probably. concentrated amon&. those
bonds that are not fully user-fee supported, (2)
the effect on revenue bonds and lease-purchase
bonds may diminish with time as local governments adjust more fully to the post-Proposition
13 environment, and (3) the effect on taxallocation bonds may definitely be understated.
Inferences regarding Proposition 13's impact
on the value of existing state-and-local debt
ideally should be derived from secondarymarket yield data for actively traded issues.
However, such data are not available, so.that
inferences are drawn here from the effect on newissue yield cost. Most existing California debt is
in the form of general-obligation and revenue
bondS (Table 5). On the basis of our findings in
the empirical section, we can presume that Proposition 13 has had no effect on the $7.3 billion of
existing local general-obligation bonds, perhaps
some effect on the $5.5 billion in revenue bonds,
and a definite effect on the $576 million of taxallocation and $2.2 billion of lease-purchase
bonds.
To measure the effect on the present value of
outstanding debt, we can calculate the impact of
the rise in new-issue interest cost on the present
value of a bond of comparable maturity. In the
post-election period, the average net interest cost
of new revenue-bond issues was 7.07 percent,
with perhaps 70 basis points of the interest-cost
rise due to Proposition 13. For tax-allocation
bonds in May 1978 (the last date any were
issued), average interest cost was 8.45 percent
and at least 250 basis points of the rise was due to
Proposition 13. For lease-purchase bonds, the
average rate (May-September 1978) was 7.17
percent, with at least 75 basis points resulting
from Proposition 13.
For these three categories of bonds, average
maturities (the averages of the "average maturities" of the serial issues) ranged from 12 to 15
years. If we assume 14-year bonds with equal
payments at the end of each year, the Proposition .13 reductions in present value are 9 percent,
28 percent, and 9 percent for revenue, taxallocation, and lease-purchase bonds respectively.33 Ifwe apply these figures to the outstanding
debt shown in Table 5, bond values are reduced
by $500 million for revenue bonds, $160 million
for tax-allocation bonds and $ 195 million for
Table 5
California State and
local Debt Outstanding 1
(millions of dollars)
General
Tax
LeaseObligation Revenue Allocation Purchase
City
$1.097
County
109
School
District
2.235
Special
District
3.852
Total
Local
State
I
$2.757
8
$
Other
0
0
$ 826
1.143
253
0
N.A.
2.519
576
194
1.1064
$7.293
$5.537
$ 576
$2.163
$3,950
$5.589
$1.I48
0
N.A.
N.A.
$ 593 2
148 2
2,103 3
Figures for local debt are of the fiscal year ending June 30,
1977.
Figures for State debt arc as of December 31, 1977.
Mostly special assessment and improvement district debt.
, Loans from the State and Public School Building Funds.
4
$566 related to construction financed by the State and U.S.
Government. $11 in time warrants. and $529 in "other
long-term indebtedness."
Sources: Staff of the Assembly Committees on Local Government and Revenue and Taxation, [3J. p. 347.
Legislative Analyst [2]. and annual reports of the
California State Controller on financial transactions concerning cities. counties. and school districts. 1976-77.
35
IV. Summary and Conclusions
ment. In contrast, tax-allocation issues have
suffered an increase in risk premium of at least
250 basis points, and there is no indication that
this premium will necessarily decline. Redevelopment agencies, the principal issuers of such
bonds,thus appear to have been the principal
debt-market casualties of Proposition 13. At this
point, the .constraints on property-tax revenues
have· ended tax-allocation bonds as a viable
sourceoffunding for redevelopment agencies.
The findihgs of this study imply that restrictions on the size of government, if properly
structured, need not increase the cost of new debt
or decrease the value of existing debt to any
significant extent. Funds needed to payoff all
existing debt could be exempted from revenue
ceilings (as was voter-approved debt under Proposition 13), thereby lessening the effect on existing debt. Alternatively, restrictions could be
placed on government expenditures rather than
revenues, thereby protecting all debt. Voters and
government officials may wish to consider such
alternatives in structuring ways to restrict government. In the meantime, municipal-bond investors should keep a wary eye on what the
voters are saying.
Proposition 13 brought on a sudden and
severe reduction in local-government revenues in
California, with all of the reduction in the form
of property-tax relief. Although the State has
provided substantial assistance to local governments, restrictions on new taxes have reduced
their expected income, thereby reducing the revenue flows needed to payoff their existing debt.
This study has shown the resulting effects on the
cost of new debt and the implications for existing
debt.
Proposition 13 apparently has had no significant effect on local general-obligation bonds
approved prior to July 1, 1978, except for perhaps some minor impact on new issues sold just
prior to the election. The effect apparently has
been nil for "pure" revenue bonds but significant
for hybrid revenue bonds, so that the average
cost of all such bonds issued since the election
increased by approximately 70 basis points.
There has also been an adverse effect of at least
75 basis points on lease-purchase bonds. For
both the hybrid revenue and lease-purchase
categories, however, the rise in the risk premium
may now be declining, in view of the existence of
state-government aid and the adaptation oflocal
governments to the post-Proposition 13 environ-
FOOTNOTES
1. As used throughout the paper, the term municipality
includes the state, all levels of local government, and
special districts.
5.. This section draws heavily from the Legislative
Analyst [2J, California Assembly Staff Report [3J and
Friedlander [4J and [5].
2. On the ballot of June6, 1978, there were actually two
competing tax-reduction alternatives-Propositions 13
and 8. Defeat of Proposition 13 and passage of Proposition 8 would have put in force a legislative act known as
the Behr Bill. This author previously hypothesized the
effects of both Proposition 13 and the Behr Bill on
California municipal debt. In all cases, hypothesized
effects were directionally the same for the two measures, although those of the Behr Bill were much
weaker. Because of the eventual passage of Proposition 13, discussion of the Behr Bill has been omitted
from this paper.
6. Because there were very few new issues, local
assessment bonds have also been excluded from the
discussion. There should be no effect on 1911 Act
assessment bonds and only minor effects on 1915 Act
assessment bonds, for which municipal revenues provide backup security.
7.ln the opinion of legislative analysts [2, p. 338], it
would be possible forthe state legislature to authorize a
new category of non-ad valorem "special tax" for the
purpose of financing capital expenditures. In this instance local governments could issue, with a two-thirds
approval of "qualified electors," G.O. bonds to be
repaid from the special tax which would fall outside the
revenue limitation of Proposition 13.
3. The $7-billion reduction h.as turned out to be an
overstatement, because of subsequent upward reassessments of market values for the 1975-76 year. See
the article by William Oakland' in this issue of the Review.
8. Although not legally obligated, local governments
have sometimes subsidized pure revenue bonds in
order to avoid default, since such action would strengthen the government's ability to float future issues. In
such cases, pure revenue bonds could be affected by
Proposition 13.
4. The meaning of the term "qualified electors" has yet
to be determined in the courts. It is not known whether it
will be interpreted as those voting or as those qualified
to vote.
36
9. In many cases, government loans and grants, as well
as fees from facilities such as parking garages, provide
additional revenue.
mUnicipal-i:)ond term structure, then net interest cost
can differ markedly from the true economic interest
cost. In California, constraints placed on the underwriters byttJe municipalities keep the coupon yields fairly
well in line with the term structure. Thus, net interest
costuseqin this study is a fairly close approximation to
true interest cost. For a full discussion, see Hopewell
aog Kaufman [8], [9],and [10], and Mendelowitz and
Rockoff [14].
10. Property that changes hands or is newly constructed after 1975-76 would be assessed at current market
value.. An unresolved question is whether the fixed
base-year assessed value for a project approved after
1975-76 would be rolled back as well. If so, Proposition
13 Would lower the base-year assessed value, which
would reduce revenue to the local taxing bodies and
increase tax=increment revenues. By itself, this effect
would strengthen tax-allocation bonds, although it
would surely be outweighed by the negative effects of
the Proposition's constraints.
16. A single rating was used for each bond. Either
Moody's or Standard and Poor's was used if oniy one of
the two organizations rated the bond. Ifboth did and
there was a discrepancy, Moody's rating was used.
17. It is necessary that MATj2:1, which holds for the
sample in this paper.
11. There are a few exceptions where the redevelopment district has little debt and considerable nonproperty-tax income.
18. The specification grew out of a use of term structure
in a paperby Hendershott and Kidwell [7]. Theirspecification was different, as it was designed to pick up a
different effect of term structure on NIC.
12. Secondary-market yield data for municipal bonds
are too scant for statistical analysis. New-issue data for
January 1,1977, through March 31,1978, were obtained
through the Public Securities Association in New York
City and the Municipal Finance Study Group at State
University of New York at Albany. They are derived
principally from the Bond Buyer New Issue Worksheets
and the Daily Bond Buyer. Data after March 31, 1978,
were taken directly from the Daily Bond Buyer. Issues
that did not report net interest cost were deleted. These
were usually negotiated or private-placement issues.
19. The risk differential is assumed to be independent of
the level of rates. This assumption is commonly accepted, although there may be some reason to believe that
the risk premium is positively related to rates. For this
argument, see Kessel's development of Hicks' theory
[11], pp. 724 and 731.
20. When average maturity is known, DTERMST is zero.
When average maturity is not known, TERMST is set
equal to ht and DTERMST is set equal to (i3Ot-htL The
coefficient of DTERMST, d1, is
13. This author has not been able to determine the
effect of legal restrictions on interest-rate ceilings. The
figure of 8 percent is often cited as a rate limit for
California debt,.but this limit must not be effective for
many redevelopment districts, as 15 of the 18 taxallocation issues after April 18, 1978, had rates in
excess of 8 percent. Three were as high as 9.7 percent.
d1
= b1x
In MAT
In 30
where In MAT is an estimate of the average of the log
average maturities for the missing data. Using In MAT
for the data with known values and b1 from the regression, one can calculate an hypothesized value for d1.
The hypothesis would merely test whether or not the
average maturity of the data with missing values was
the same as that for data with known maturities.
14. See in particular, Hendershott and Kidwell [7],
Kessel [11], Kidwell [13], Tanner [16]. Variables are
omitted from this analysis, as they are in other empirical
analyses. Differences in coupon patterns would affect
the interest differential, as would the whole term structure of interest rates, because coupons are expected to
provide future reinvestment income at rates implied by
the whole term structure. Tax effects should also be
included, even for municipal bonds, because capital
gains/losses have tax effects. Also, probability functions for default and call should be included. The state
of the art and limitations of the data preclude much
headway in including these variables. For evidence on
call privileges, see Kidwell [13].
21. There is considerable random variation in NIC
across issues, and they are not issued uniformly over
time.
22. There is some ambiguity about general-obligation
bonds issued after July 1, 1978. Proposition 13 states
that G.O.'s approved after its implementation (July 1)
would be subject to property-tax ceilings. However, in
those few cases where the author was able to check, the
bonds issued were all approved prior to July 1 (one as
early as 1973).
15. In the municipal-bond market, bonds are almost
always sold to underwriters in a package known as a
serial issue. A serial issue will have many .bonds with
different coupons and maturities, and for the package
an "average maturity" and "net interest cost" (average
interest ratel will be calculated. Average maturity, is a
simple weighted-average of the maturities of the individual bonds in the issue. Net interest cost is a
weighted-average of coupon yields of the different
bonds in the issue without regard to when the coupons
are paid. Thus, future coupons are implicitly discounted at a zero rate of interest, and coupons in the first year
are given the same weight as those in the last year. If the
coupons imply rates on the par-value bonds that differ
markedly from the rates in the reoffer yields or in the
23. The Chi-Square test was used to test whether or not
the 1977 and 1978 distributions came from the same
underlying popu lation.
24. los Angeles Times, April 12, 1978, and Moody's
Bond Survey, Vol. 70, No. 16, April 13, 1978, pp. 13391341.
25. On June 8, sap suspended ratings on all but voterapproved, full faith and credit general obligations,
insured bonds, revenue bonds 1DO-percent enterprise
supported, pre-refunded bonds fUlly secured by U.S.
government obligations, and institutionally-supported
37
were one-year tax anticipation notes that did not require specific voter approval.
revenue bonds. In all, ratings on 248 existing leasepurchase, tax-allocation, special-assessment, and
hybrid-revenue issues were suspended "due to lack of
sufficient information regarding the action to be taken
by the various •levels of California government in response to the passage of the Jarvis-Gann Initiative."
(Standard and Poor's release, June 8, 1978l. Moody's
contil)ued to rate lease-purchase bonds, and the two
post-election issues were rated A and A-1.
29. Redevelopment districts began to issue mortgagebllckedrevenue bonds after the election, whereas none
wereisSUedpriorto the election. (Tax allocation debt
wasissuedinsteadJ These bonds have had net interest
cost.Ssomewhat. higher than the average for postelection revenue bonds.
3Q.Thecoefficienton TERMST should be approximateIyequal to one. This result holds for the other three
categories of bonds. However, for all regressions run
on lllxll"ocation bonds, the coefficient was zero or
slightly negative. This result occurred even for equation
(1) fitted to 1977 data.
26. Asa test for stability of coefficient values and mode!
structure, equation (1 )-including a time trend for
WEEK77.......was Jitted for 1$77, and the results were
tested against those of equation (2) for 1977-78. The
coefficients and the standard errors were generally
found to be robust with respect to the time period
tested. Also, predictions were made for the postelection period using equation (1) fitted to 1977 data.
The post-election prediction errors were close to the
time-shift estimates of equations (2) and (3) fitted to
1977-78 data.
3t.Because oflack of sufficient data, issues dated May
1, 1978, and thereafter are used to represent the postelection period for tax-allocation and lease-purchase
bonds.
32. For lease-purchase bonds, equation (2) understates
the effect of Proposition 13. As mentioned earlier,
equation (3) . gives a more accurate estimate. Using
equation (1) estimated on 1977 data, the predicted
effect ofproposition 13 in the "post-election" period
(after May 1) was found to be 77 basis points.
27.Thefigure of 20 basis points is calculated, using the
coefficients in Table 3a and allowing for the fact that
WEEK78 had a duration of 22 weeks:
3.5 x 22 - 57
= 20.
28. In a previous section of the paper, an effect on
general-obligation bonds approved after July 1, 1978,
was hypothesized. It appears that the G.O. bonds in the
sample either were approved prior to July 1, 1978, or
33. The effect on present value of an individual bond
would differ from these figures, depending on the
maturity of the bond and the probability function for
expected default.
REFERENCES
National Tax Journal, December 1974.
9. Hopewell, Michael H., and George G. Kaufman,
uThe Municipal Bond Auction: Reply," National
Tax Journal, March 1976.
10. Hopewell, Michael H., and George G. Kaufman,
"The Incidence of Excess Interest Costs Paid by
Municipalities in the Competitive Sale of Bonds,"
Journal of Monetary Economics, April 1978.
11. Kessel, Reuben A., "A Study of the Effects of
COmpetition in the Tax-Exempt Bond Market,"
Journill of Political Economy, Vol. 79, 1971.
12. Kidder,Peabody & Co., The Jarvis Initiative-Its
Impact on California Municipal Bonds, undated
(about May, 1978).
13. Kidwell., David S., "The Ex Ante Cost of Call Provisions on State and Local Government Bonds,"
Journal of Economics and Business, Fall 1977.
14. Mendelowitz, Allan I., and Hugh Rockoff, "The
Municipal Bond Auction: An Alternative View,"
Niltion.al Tax Journal, March 1976.
15. Stigler, George J., "The Economics of Information,"
JournillofPolitical Economy, June 1961.
16. Tanner,J. Ernest, "The Determinants of Interest
Coston New Municipal Bonds: A Reevaluation,"
Journal of Business, January 1975.
17. Twentieth Qentury Fund, Task Force on Municipal
Bono Qredit Ratings, John E. Petersen, Chairman,
The Rating Game, Report oUhe Task Force, New
York: The Twentieth Century Fund, 1974.
1. Borys, Michael J., and John F. Santoro, "An Analysis of the California Bond Market in 1978," Municipal Market Developments, Public Securities Association, New York City, November 9, 1978.
2. Clllifornill Legislature, Joint Budget Committee,
Legislative Analyst, An Analysis of Proposition 13,
The Jarvis-Gann Property Tax Initiative, Sacramento, No. 78-11, May 1978.
3. California$taff to the Assembly Committees on
Local Government and Revenue and Taxation, The
Impact of Proposition 13 on Local Government
Programs and Services, Sacramento, California,
May 1978.
4. Friedlander, George D., "The Jarvis-Gann Initiative,
ATaxpaYerj=3evolt in California: Implications for
Municipal Bonds," Smith Barney, Harris Upham &
Co., February 3, 1978.
5. Friedlander, George D., "The Jarvis-Gann Initiative,
the. 'Behr Bill' and the Investment Climate for California Municipal Securities," Smith Barney, Harris
Upham & Co., April 4,1978.
6. Hempel, George H., Measures of Municipal Bond
QUilllty, Michigan Business Report No. 53, The
University of Michigan, 1967.
7. Hendershott, Patrie H., and David S. Kidwell, "The
Impact of Relative Security Supplies," Journal of
Money, Credit, and Banking, August 1978.
8. Hopewell, Michael H., and George G. Kaufman,
"Costs to Municipalities of Selling Bonds by NIC, "
38
John P. Judd*
come the obstacles to paper-market entry, eligible firms became very responsive to relative costs
in deciding between alternative means of finance.
Since bank credit is almost unavoidably more
expensive than paper-market credit, the switch
to the latter market is not likely to be reversed in
the foreseeable future.
Many large, financially sound nonfinancial
corporations have relied primarily on the
commercial-paper market for short-term funds
during the prolonged business expansion of the
late 1970's. This important new development in
short-term corporate finance has occurred largely at the expense of the money-center banks in
New York and other major financial centers.
According to our analysis, this development
stems from the unavoidably higher costs of bank
as compared to paper-market credit, as well as
the relatively low value of the intermediation
"services" which banks can provide to potential
commercial-paper borrowers. Thus the observed
trend represents an improvement in the efficiency of the U.S. financial system.
Given these considerations, why did these
firms not switch to the commercial-paper market
at some earlier date? First, given the consistently
low interest rates of the 1950's and early 1960's,
they did not feel justified incurring the costs of
developing and maintaining the staff expertise to
actively manage liquid assets and liabilities.
Corporations established a pattern of dealing
primarily with banks, even though deposit yields
were somewhat lower, and loan rates somewhat
higher, than those in the open-market. This
restricted commercial-paper growth, from both
the supply and demand sides of the market.
Second, even after interest rates began their
secular rise in the mid-1960's, corporate borrowers remained uncertain about switching to the
paper market, because this meant departing
from (and possibly damaging) long-standing and
difficult-to-replace bank relationships. But the
greatly reduced availability of bank credit in the
credit "crunches" of 1966 and 1969-70 created a
new financial environment. Once having over-
This development has several important policy implications. Commercial-paper issuers almost always include the most financially sound
firms in the economy, and their reduced use of
bank loans thus implies greater riskiness of
bank-loan portfolios. The probable permanence
of this phenomenon should interest bank regulators in setting capital-adequacy standards. Furthermore, the switch to commercial paper by
many prime-rated bank loan customers reinforces the postwar trend toward greater bank
eXDosure to financial-market risk caused by the
de~line in capital cushions and holdings of lowrisk financial investments. It has been pointed
out elsewhere that banks now use liability management as their main source ofliquidity, so that
regulatory actions which limit the flexibility of
this tool could contribute to a liquidity squeeze. l
The impact of these recent developments varies with the .region and size of banking institutions, with the strongest effects felt by the large
banks in New York City and, to a lesser extent,
Chicago and San Francisco. Commercial-paper
market growth helps account for the widely
discussed weakness in loan demand at moneycenter banks earlier in the current cyclical expan··
sion. Furthermore, the spurt in loan demand
which large banks typically experience near the
end of expansions, when their highly liquid
customers finally run low on liquidity, may be
less pronounced at future cyclical peaks.
*Economist. Federal Reserve Bank of San Francisco. Margaret Whack and Thomas Klitgaard provided research
assistance for this paper.
Finally, the borrowing cost advantage of paper over loans has risen above the level at which
39
loan movements could be misleading, at least
until enough time has elapsed for new statistical
relationships to be estimated.
The first section of this paper discusses certain
theoretical considerations relevant to the competitiveness of intermediaries vis-a-vis directfinance markets. The second section discusses
specific institutions and characteristics of the
commercial-paper and bank-loan markets. The
third section describes and analyzes the postwar
changes in the relationship between these two
markets, and this is followed by a discussion of
policy implications.
many eligible firms have substituted almost
entirely into paper. Thus, further moderate
changes in relative borrowing costs do not cause
substantial substitution between paper and
loans. This development may enhance the usefulness of business loans as a business-cycle indicator. Since the prime rate-paper rate spread
should be a less-important determinant of
business-loan demand than it has been in the
past, the correlation between loans and business
spending (and thus the business cycle) may be
greater. However, attempts to use estimated
loan-demand relationships to forecast business-
I. Direct Finance Versus Intennediation
Financial markets can contribute to economic
growth by efficiently allocating the funds of net
savers in the economy among economic units
engaged in capital formation. 2 This transfer of
funds between units with savings surpluses to
those with savings deficits can take two forms:
direct finance and intermediation. Direct finance
occurs when a deficit unit sells a financial instrument to a surplus unit. Intermediation occurs
when a deficit unit borrows from a financial
intermediary-such as a bank-which in tum
sells a financial instrument to a surplus unit. In
order for savings to be optimally allocated
among competing real-investment opportunities, the transfer of funds between surplus and
deficit units must be accomplished in the least
costly way.
Intermediaries transform the direct debt of ultimate borrowers (e.g., bank loans) into indirect
debt (e.g., bank deposits) for sale to ultimate
lenders. In doing so, banks are able to pool the
funds of a large number of small savers to make
loans of varying sizes to borrowers. This helps
borrowers avoid the cost and inflexibility of
dealing with a number of small lenders, and
provides attractively denominated investments
for savers. Banks are also able to loan funds at
different maturities than those at which they
borrow. Thus, ultimate lenders and borrowers
can gain greater flexibility in choosing maturities
than they could do with direct finance.
Lenders and borrowers also may be able to
obtain reductions in risk by using intermediation
rather than direct finance. Because banks have
large portfolios, they can profitably make loans
and purchase securities across a broad spectrum
of types and maturities. At any point in time, this
diversification reduces the risk of the entire
portfolio compared to that of the individual
financial assets. Thus banks can offer savers
indirect debt which generally has greater liquidity than the direct debt of ultimate borrowers.
Because of their portfolio diversification as well
as their capital cushion, banks can also reduce
risks experienced by firms over periods of time
such as business cycles. In addition, banks can
allocate funds less expensively than certain borrowers and lenders, through exploiting economies of scale and specialization. Banks can incur
economies of scale because of the large number
and volume of their loans and investments. Also,
they can reduce costs because of their expert
Economic functions of banks
Banks and other financial intermediaries exist
because of their ability to channel funds between
certain types of lenders and borrowers at a
smaller cost than is possible through direct
finance. If this were not the case, lenders and
borrowers would tend to use existing means of
direct finance, or would tend' to create new
financial markets. But how are financial intermediaries able to compete with direct finance markets? Banks, for example, are often large corporations with substantial operating costs-costs
which can be avoided when borrowers sell securities directly to lenders.
Financial intermediaries are able to compete
because they provide a number of services which
are attractive both to lenders and borrowers.
40
knowledge, gained through specialized investing
and dealing with ultimate borrowers and savers.
Finally, the personal contact between bankers
and their customers allows transactions and
pricing mechanisms to be finely tuned to customers' needs, and allows banks to acquire very
specific financial and other information. These
advantages can grow with the length of the
bank/ customer relationship, because information on both sides becomes more precise over
time. Many firms consider a solid banking relationship to be an essential part of doing business.
Long-standing customers benefit because banks
will often make loans to them when they experience temporary financial difficulties or when
credit availability is limited overall. Since the
open market is generally less dependable in these
situations, firms can eliminate a great deal of
cyclical uncertainty by staying on good terms
with their bankers. In addition, banks can develop very accurate credit profiles on long-standing
loan customers. Except where they are large
enough for national recognition, firms may be
able to obtain loans at lower rates from banks
than from the open market.
Clearly, the value of bank services is difficult
to measure, and varies between different ultimate borrowers and lenders. For example,
smaller lenders especially may find certain bank
services valuable, such as investment expertise,
economies of scale, risk reduction, divisibility
and flexibility. Smaller, weaker borrowers may
find the personal bank relationship valuable~
certainly more so than large nationallyrecognized firms---because with that relationship, cyclical risks can be reduced and credit
profiles can be based primarily on personal evaluations.
the rate they can earn on bank deposits (and
other liabilities), Rb, plus the yield equivalent of
the value of bank services (')I) to the rate they can
earn on open-market securities (Rs). As
Rs-Rb- ')I rises, lenders will supply a larger
quantity of credit to the open market compared
to banks.
(I)
OM'
(OMS + BS )
0'
Where, 0 M
+ (3 (Rs-Rb-')I) +}.. Y, ;(3 > 0
S
supply of credit to direct finance or open markets
S
B = supply of funds to banks
Y = unspecified exogenous variables
Rs, Rb, 'Y = defined in text.
Ultimate borrowers compare the bank loan rate
(R I) less the yield equivalent of the value of the
bank services (')I') to the rate they must pay on
open-market securities. As RI- Rs - ')I' rises,
borrowers will obtain a larger proportion oftheir
external funds through the open market compared to banks.
~M
d
d
OM + B
=
Where, OM
0"
+ (3'(RI-Rs-')I')
+ }..'Y' ;(3' > 0
d
(2)
demand for direct finance, or
open-market credit
d
B = demand for bank credit
Y' unspecified exogenous vanabies
R I, Rs, ')I' defined in text
Consequently, the net effect of these two choices
is that lenders and borrowers will channel a
smaller proportion of funds through banks if the
bank spread, RI-Rb, rises relative to the cost of
channeling funds through the open market.
These open-market costs are the value of bank
services foregone by lenders and borrowers, plus
any explicit costs associated with the direct
transfer, such as brokerage fees. Since these costs
are likely to be relatively stable in the short run,
the volume of direct finance compared to bank
intermediation should vary positively with
changes in the bank spread. This relationship can
be derived by solving equations (I) and (2) for
market equilibrium (reduced-form) values of
Banks and direct markets
Banks provide such services in order to earn a
profit; specifically, by charging a large enough
spread between their lending rates (RI) and their
depositor borrowing (or deposit) rates (Rb) to
cover the costs of doing business, including a
premium for risk-taking. But the size of the
spread they can charge is limited by competition
with other intermediaries and other financial
markets. In choosing between a bank and a
direct finance market, ultimate lenders compare
41
Thus banks can alter their relative attractiveness
direct finance markets either by changing RI or Rb. For example, if R I rises, the
demand for bank as compared to open-market
creditfalls. This requires an· increase in Rs to
equate supply with demand. The same reduction
of. the credit flow can be accomplished by
decreasing Rb. This will reduce the supply of
credit to banks relative to open-market credit,
and will. require a decrease in Rs to equate
demand with supply.
OM
and assummg that y and y' are
OM+B
constants.
OM
f3f3'
---=---=-- = constant + - - (RI
OM + B
f3 + f3'
+
(3A'
f3 + f3'
Y'
vis~a-vis
Rb)
+ JfL Y
f3 + f3'
where constant = af3'
+ f3a' - f3f3'(y + y')
f3 + f3'
(3)
II. Commercial Paper Market Versus.CommercialBanks
The abstract principles and choices discussed
in the previous section are carried out in the
economy through a complex system of different
intermediaries and financial markets. This article is concerned with the relationships between
intermediation through large money-center
banks (such as those in New York), and direct
finance through the nonfinancial commercialpaper market. These two types of institutions can
be characterized as competing for the flow of
short-term credit from large financial and nonfinancial corporations to other large, highlyrated nonfinancial corporations. In order to
analyze recent developments in their ongoing
relationships, we must consider the institutional
framework in which they operate.
gain access to the market, however, issuers
generally must maintain bank lines-of-credit,
often in amounts equal to their paper outstanding. Well over 700 firms hold commercial paper
ratings. 4 Of the three ratings available (Prime-I,
Prime-2, and Prime-3), only the highest two
provide ready access to the market. Furthermore, interest rates on the paper of P-2 rated
firms run about 25 basis points higher than the
rates on P-I rated paper at present.
Finance companies are the largest single group
of commercial-paper issuers. Because of their
large and steady needs for financing their relatively short-term assets, they place most of their
debt direGtly in the commercial-paper market
with the help of permanent sales staffs. s Once
firms make the fixed investment in sales facilities, acquire the necessary investor contacts, and
commit themselves to "making" a market in
their paper, they tend to rely primarily on commercial paper and only secondarily on bank
loans. Thus, since we are concerned with the
competition between banks and the paper market, we do not discuss finance-company paper
further.
Nonfinancial corporations are the second
largest group of paper issuers. These firms use
the paper market primarily to finance short-term
or seasonal expenditures on such items as inventories, payrolls and tax liabilities. They issue this
paper through dealers, since the size and/ or
consistency of their borrowing needs do not
justify placement through their own staffs. 6 In
addition, nonfinancial companies sometimes use
the. paper market to obtain temporary funds,
Borrowers
Commercial paper consists of short-term promissory notes issued by both nonfinancial and
financial corporations. 3 In the third quarter of
1978, total commercial paper outstanding
reached $75.3 billion~ofwhich $44.9 billion was
issued by nonbank financial companies (almost
entirely sales- and personal-finance companies),
$17.7 billion by nonfinancial corporations, and
$12.7 billion by commercial-bank holding companies (Chart I). Original maturities of commercialpaper range from one to 270 days, but
average less than 60 days. This method of finance
is limited primarily to large, highly-rated, and
often nationally known firms, because commercial paper is usually not secured by any specifically designated collateral~although it does of
course have debt's prior claim over equity. To
42
when they wish to delay bond sales in anticipation of more favorable market conditions. Shortterm bank loans provide their major alternative
source of funds to paper-market sales. Since
these firms generally represent potential customers of the large money-center banks, the best
available measure ofthe paper market's competitionis provided by the short-term commercial
and industrial loans (excluding bankers' acceptances) of selected large weekly reporting banks. 7
In 1978:3, these bank loans outstanding totaled
$55.0 billion (Chart I).
Not all nonfinancial paper is issued by domestic firms. Foreign corporations, especially
French utilities, have issued increased amounts
of paper since shortly after the removal in 1974 of
U.S. controls on capital outflows and foreign
controls on capital inflows. These borrowers,
who apparently do not usually use U.S. bank
loans, have entered the U.S. paper market because of the sizeable spread between European
bank-loan rates and U.S. commercial-paper
rates. Starting from a base of almost zero in
1974, their outstandings represented roughly 10
percent of nonfinancial paper at the end of 1977. 8
In making short-term financing decisions,
prime-rated domestic nonfinancial corporations
weigh the relatively high cost of borrowing from
banks versus issuing paper against the unique
services offered by banks. The spread between
the bank prime-lending rate and commercialpaper· yields is the major element in the
borrowing-cost differential. 9 In the current economic expansion (1975:2-1978:3), the primerate spread has varied from 90 to 156 basis
points, and has averaged over 125 basis points
(Chart 2). Despite the large spread, banks have
been able to attract some prime-rated loan customers during this period because of the risk
protection and other services they offer.
Lenders
Relatively little quantitative information is
available on the amounts of commercial paper
held by various types of investors. However,
survey information indicates that the major
holders are nonfinancial corporations, and that
less significant quantities are held by bank trust
departments, small country banks, insurance
companies, private pension funds, state and local
governments, investment companies and foundations. Many of these firms buy commercial
paper with funds temporarily available for a
predictable period of time. For example, a nonfinancial corporation might buy paper with cash
needed to meet a payroll in a certain known
number of days. Alternatively, the firm might
purchase some other money-market instrument,
such as large negotiable certificates of deposit
(CD's) or Treasury bills.
Unlike most other money-market instruments, commercial paper has no established
secondary market. This problem is largely overcome, however, by the tailoring of maturities to
fit investors' needs. Thus in the example above,
the corporation could buy paper which matures
on the day the payroll is due, instead of buying a
longer-term CD and selling it in the secondary
mark.et when cash is needed. Furthermore, if a
commercial-paper holder experiences unforeseen cash needs, many direct-placers and dealers
will buy paper back prior to maturity, especially
Chart 1
Commercial Paper and
Short·Term Business Loans
Outstanding
$ Billions
80
Total commercial paper
~
60
Short- term business loans
40
20
10
1969
1971
1973
1975
1977
Source: Federal Reserve Bank of New York and Board of Governors of the Federal Reserve System.
43
if the holder is a regular customer. The spread
between the commercial paper rate (RCP) and
the CD rate (RCD) has averaged only one basis
point, and has varied between -16 and 12 basis
points, over the 1975:2-1978:3 period (Chart
2).1 The small spread reflects the fact that
0
holders of CD’s do not receive the substantial
bank services obtained by holders of smalldenomination deposits. In buying a large CD,
the investor is simply purchasing a moneymarket security which happens to be issued by a
bank.
with both the assets and liabilities of commercial
banks. On the bank asset side, commercial-paper
sales are the major alternative to bank loans to
prime-rated nonfinancial corporations. On the
bank liability side, commercial-paper purchases
are a major alternative to bank CD’s for corpo
rate investors of temporarily idle cash. Thus, the
commercial-paper market offers eligible corpo
rations the opportunity to borrow from and lend
to each other without the intermediary services
of commercial banks.
The spread between the prime bank-lending
rate (RP) and interest rates paid in the dealerplaced commercial-paper market (RCP) should
be an important determinant of the supply of
Interaction between borrowers and lenders
The commercial-paper market is competitive
Chart 2
Yield Spreads
Percent
Note: Paper rate equals yield on a 4-6 month prime commercial paper. CD rate equals yield on 90-day large
negotiable CD’s. Prime rate equals prevailing rate on prime business loans at large banks.
44
nonfinancial paper. The spread between yields
obtainable in the dealer-placed commercialpaper market (RCP) and yields on alternative
assets such as CD's (RCD) should importantly
influence the demand for nonfinancial paper. By
subtracting the demand-side yield spread
(RCD-RCP) from the supply-side yield spread
(RP-RCP), we obtain what we will call the bank
spread (S=RP-RCD), which summarizes the
incentives of both demanders and suppliers when
deciding whether to channel short-term corporate credit through banks or through the paper
market. (The bank spread is the rate spread
which would appear in a reduced-form equation
for the stock of commercial paper.)11 When the
bank spread rises, for example, a greater proportion of this credit flow can be expected to go
through the commercial-paper market. This
involves some loss of risk protection and other
bank services, but is presumably offset by the
lower cost of channeling the funds.
As an empirical matter, this approach involves choosing a measure of the total flow of
credit to be divided between the bank and papermarket channels. In theory, this measure could
be obtained equally well from the liabilities of the
borrowers involved, or from the assets of the
lenders; in practice, available data suggest the
use of the liability measure. Furthermore, as
noted earlier, both the level and the changes in
the bank spread have been explained primarily
by the prime rate-paper rate spread faced by
borrowers, rather than by the paper rate-CD rate
spread faced by lenders (Chart 2). Thus most
(but certainly not all) of the "action" in the
bank/ paper relationship has been related to
changes in the financial incentives of borrowers.
For these two reasons, we will focus henceforth
on movements in one particular ratio, with the
numerator representing total nonfinancial paper
outstanding, and the denominator representing
that same paper outstanding plus an estimate of
total short-term bank loans to those nonfinancial corporations who are potential issuers of
paper. 12
III. Changes in the Paper Market-Commercial Bank Relationship
eligible corporations relied primarily on loans,
using paper only as a supplementary source of
funds. 13 Perhaps corporate bank customers did
not shift into the paper market at that time
because they placed a high value on the services
which banks offered to their regular customers.
But this can be only a partial explanation,
because these services-such as cyclical risk
reduction and credit ratings based on personal
experience-probably are not valued highly by
many of the large well-known firms eligible to
issue commercial paper.
Throughout the lengthy period oflow nominal
interest rates prior to the mid-1960's, large
corporations maintained a strong tradition of
primary reliance on banks for short-term credit.
They recognized the potential gains obtainable
from managing assets and liabilities with sophisticatedtechniques, but did not believe the gains
were large enough to justify the costs. This
situation inhibited the growth of the
commercial-paper market from both the demand and supply sides. Corporate treasurers
were content to leave large sums of liquid assets
Prior to the "credit crunches" of the mid-tolate 1960's, large commercial banks played the
dominant role in the short-term financing of
prime-rated corporations, despite significantly
lower borrowing costs in the commercial-paper
market. During the "crunches," many of these
borrowers were introduced to the paper market,
and in the first half of the 1970's became highly
sensitive to the relative borrowing costs of loans
versus paper. Since 1975, however, this degree of
substitution has fallen dramatically: many eligible firms now meet their short-term credit needs
primarily in the paper market, and obtain loans
only as a supplementary source of funds. Why
have they switched from intermediation to direct
finance? Is this a permanent switch, or is it soon
likely to be reversed?
Pre-"credit crunch" era
Prior to the late 1960's, the prime rate-paper
rate spread consistently favored the paper market. During the 1961-65 period, for example, the
spread (calculated with the 4-6 month paper rate)
averaged 88 basis points. Despite this spread,
45
in low~interest or noninterest~bearingbank deposits, and thus reduced the supply of funds to
the money markets. In addition, they were often
content to· ignore interest-cost minimization
when managing their liabilities, and thus limited
the demand for money-market funds. 14
The situation did,not change significantly even
when short-term interest rates began their secular rise in the early 1960's. After years of experience in dealing with each other, banks and their
customers had typically worked out a subtle set
of individually designed services and associated
(explicit and implicit) prices. Since these arrangements were based on personal contactson personal "loyalty," even-they could not
easily or quickly be established elsewhere. Thus,
a customer who obtained more than a token
amount of credit from the paper market (the
bank's competitor) could seriously disrupt a
smoothly-functioning bank relationship. Indeed, a 1964 survey of large corporations found
that 60 percent did not increase their commercial
paper outstanding for fear of straining bank
relationships. 15 A potential borrower in the
paper market might be wary of entering a relatively long-run commitment to an untested
source of funds. The expected profits might be
attractive, but the risk associated with these
profits might also be large. Also, such an action
might involve certain fixed start-up costs, such as
actually developing the necessary expertise in
using the market. For firms with professional
personnel trained in the tradition of bank financing, these costs could be substantial. Thus,
strong financial incentives were necessary to
push eligible firms over the threshold into primary or even significant reliance on commercial
paper.
Two basic factors converged in this period to
push many eligible nonfinancial corporations
over the threshold into the commercial-paper
market. Ule first was the upward trend in shortterm interest rates. As explained above, this
motivated corporations to manage their liquid
!lssetsand liabilities actively, and thus set the
stage for growth from both the demand and
supply sides of the paper market.
Jhe second factor, which determined the timing of the rapid paper-market growth, was the
"credit crunches" of 1966 and 1969-70. Banks
had difficulty meeting strong loan demand during these periods of disintermediation, when
open-market interest rates rose above the Regulation Q ceilings on CD rates, During these
periods, banks actually encouraged their financially strongest customers to issue commercial
paper, and offered them lines of credit to back
their outstanding paper. Borrowers entered the
paper market who had previously hesitated to do
so, despite lower borrowing costs, for fear of
straining bank relationships. In addition, for
many firms, reduced credit availability for the
first time gave them a reason to incur the "startup" costs associated with greatly increased reliance on the paper market.
Disintermediation in the late 1960's thus
caused a sharp upward-and irreversible-shift
in nonfinancial corporate use of the commercialpaper market. 16 Commercial banks essentially
have conceded that their prime-rated customers
can substitute between paper and loans without a
substantial loss of other bank services. Indeed,
banks have greatly assisted the subsequent
growth of the commercial-paper market by
granting lines-of-credit, with standard compensating balance requirements, to support outstanding commercial paper. Not being able to
obstruct the market's development, the banks
have apparently decided to profit as much as
possible from its growth.
"Credit crunches"
In the latter half of the 1960's, the commercialpaper market underwent dramatic growth, During 1965-70, total commercial paper outstanding
increased from $9.8 billion to $37,1 billion-an
annual growth rate of 26.6 percent, compared
with the 14.7-percent average growth of the
preceding five-year period. Nonfinancial paper
accelerated even more sharply than the market as
a whole, growing at a 34.4-percent annual rate
during 1965-70, as against the 1l.2-percent average growth of the 1960-65 period,
Post-"credit crunch" era
In the first half of the 1970's, prime-rated
nonfinancial corporations allocated their shortterm credit flows, through either the banks or the
paper market, on the basis primarily of the
relative costs involved (Chart 3), Indeed, a strong
positive relationship existed between the proportion of nonfinancial paper and short-term bank
46
borrowing accomplished through the paper market (P), and the bank spread (S=RP-RCD). As
the cost of channeling funds through the intermediary (commercial banks) rose, nonfinancial corporations channeled a greater proportion
of short-term credit through the open-market
alternative (the paper market). But the relationship between P and S has clearly broken down
since 1975, as will be seen below.
to a high of $3.5 billion (0.65 percent of total
loans) in 1976. 20 This experience increased the
perceived riskiness of loan portfolios, causing
banks to seek compensation by increasing the
risk premium included in loan rates. Another
contributing factor was the growing concern by
banks and their regulatory agencies about the
adequacy of capital relative to bank assets. For
V.S. insured commercial banks, the ratio of
equity to total bank assets (less cash and V.S.
Government securities) declined fairly steadily
from 14.1 percent in 1963t08.0percentin 1974. 21
This decline represented an erosion in the cushion provided by bank capital to depositors
against loan losses, and may have led to regulatory pressure restricting further growth in loan
portfolios.
Banks also tended to maintain a high spread
because of two increasingly common features of
their prime-rate setting behavior. First, banks
often tie rates on existing loans to those on new
loans, as a means of protecting themselves
against the risk of rapidly rising interest rates.
Profits can be squeezed when rates rise, because
bank liabilities generally have shorter maturities
than bank assets-but this problem can be allevi-
In view of the increased responsiveness of
paper-market growth to relative-cost considerations, the typical pre-crunch bank spreads of 50
basis points or more should have stimulated
much greater paper utilization. This, in fact,
happened in 1970-71. 17 But in 1972-73, interestrate controls artificially depressed the bank
spread, and this temporarily postponed the expected growth in the paper market. As part of the
general program of wage and price controls
initiated in 1971, the Committee on Interest and
Dividends developed voluntary controls on certain "administered" interest rates, including the
bank prime-lending rate. 18 Because of these
restraints, the bank spread actually became
negative in the first three quarters of 1973. Thus,
not surprisingly, the commercial paper share of
the market declined, with P falling from almost
17 percent to just over 11 percent between 1972:2
and 1973:3.
With the removal of controls, large banks were
able to re-establish conformity between desired
and actual prime rates, and the spread jumped
from -74 to 96 basis points between 1973:3 and
1974: I. This stimulated an almost immediate
increase in the commercial paper market share,
with P rising from 11.2 percent to 15.6 percent.
Then, in 1974-75, the prime rate increased even
more sharply. Large banks established a roughly
ISO-basis point spread between their prime-loan
rate and the commercial paper (and CD) rate, a
new high for the post-1966 period. As a result,
they lost a significant portion of the short-term
credit market to commercial paper.
Why, in the face of such stiff competition, did
banks increase their rates so sharply?19 First,
large loan losses suffered during the 1974-76
period probably contributed to the high spread.
Net loan losses for V.S. insured commercial
banks rose from an average of about $1.0 billion
(0.25 percent of total loans) in the 1971-73 period
Chart 3
Substitution Between Commercial Paper
and Short-Term Bank Loans
Percent
Percent
3.00
24
20
16
Ratio of nonfinancial
paper to paper
plus short-term
bank loans
2.50
2.00
If\;-
1.50
1.00
.50
0
12
-8
-.50
-1.00
1970
1972
1974
1976
1978
Note: Data are seasonally adjusted. Bank loans are business
loans, excluding bankers acceptances, from selected
large banks (see footnote 7).
Sources:Board of Governors of the Federal Reserve System:
Federal Reserve Bank of New York.
47
gent movements. First, a number of firms have
entered the paper market for reasons unaffected
by changes in the rate spread. But most
importantly, many firms already in the paper
market have reduced their short-term bank-loan
balances to very low levels, and have thus
gtopped actively substituting between paper and
loans.
As noted earlier, several large foreign utilities
have entered the paper market since 1974, apparently to take advantage of the large spread
betwee.u El.lropean bank-loan rates and U.S.
commercial-paper rates. For example, in 1977:4,
the French prime bank-loan rate was 11.35
percent, compared toa 90-119 day U.S. prime
commercial paper rate of 6.55 percent. Foreign
issuers have reportedly accounted for about one
third of nonfinancial-paper growth since mid1974. When this foreign paper is deducted from
total nonfinancial paper, the paper market share
(P) is reduced from 23.7 to 21.7 percent in 1977:4.
ated if rates charged on existing assets increase
along with market rates. In early February 1977,
about two-thirds of short-term loans and threefourths of long-term loans extended by large
banks carried these floating rates. 22 Second,
many banks set interest rates on new nonprime
loans to established loan customers at a predetermined mark-up over the prime rate. This practice
simplifies the process of setting loan rates once a
particular mark-up has been established for a
regular loan customer. Both of these practices
have become increasingly popular in the recent
environment of high and variable inflation and
interest rates. This rate-setting approach lowers
the marginal revenue gained by reducing the
prime to compete for new loan customers, and
thus tends to raise the spread over the paper rate.
Finally, sharp increases in the rate spread may
themselves cause a reduction in the elasticity of
overall loan demand. A high prime rate induces
some commercial-paper issuers to accomplish
most, if not all, of their short-term financing
through the paper market. This means that a
larger proportion of remaining bank loan customers are those who cannot shift to
commercial-paper financing when bank-loan
rates rise. With rates on nonprime loans often
tied to the prime, prime-rate changes serve the
dual role of competing for two sets of loan
customers: those with elastic and those with
inelastic demand curves. As the prime rate rises
and prime-rated firms switch to the paper market, the elastic demand for loans has less effect on
bank revenues. Thus further increases in the
prime rate are induced by the decreased elasticity
of overall loan demand. In addition, the riskiness
of bank-loan portfolios rises when prime-rated
firms reduce their reliance on bank loans. This
causes further prime-rate increases as banks tie
existing and new non-prime loan rates to the
prime rate. 23
The same type of development has been evident on· the domestic side, as more and more
eligible firms have become convinced that high
bank spreads are here to stay. In 1976, the
number of firms rated by Moody's Investors'
Service grew at a 17.2 percent pace, compared to
very small or negative growth rates in 1972-75.
But entry as a source of further paper-market
growth is limited by the number of companies
who qualify as potential issuers of paper. This
source of growth may already have been largely
used up. In 1977, the number of firms rated by
Moody's grew only 4.3 percent, despite the
continued large cost incentives to enter the
market.
Perhaps the most important reason for the
apparent paradox of a declining spread and
rising paper-market share is the maintenance of
the spread well above the threshold which had
already attracted heavy paper-market usage by
most eligible firms already in the commercialpaper market. A 1977 survey of Fortune 1000
companies suggests that many eligible firms are
now relying primarily on the commercial-paper
market for their short- and intermediate-term
funds. 25 About 35 percent of the surveyed first
500 and 19 percent of the second 500 do not
borrow at all from commercial banks. Of the
remainder of these two groups, 53 and 9 percent,
Commercial-paper era
Since about early 1976, the relationship between the bank spread and commercial-paper
usage has broken down (Chart 3). Commercial
paper as a proportion of short-term debt rose
from .19.0 percent in 1976:1 to 24.3 percent in
1978:3, despite a decline in the rate spread, from
162 to 110 basis points, over the same period. 24
Two factors help explain these apparently diver48
respectively, have issued paper in the past. Reasons cited for using loans in addition to paper
include: primarily as a back-up credit line to
paper outstandings (48 percent); as a more flexible source of funds (44 percent); and as a significant source of funds whenever a "reasonable"
cost difference exists between bank credit and
commercial paper (40 percent).
Once the spread rises significantly above levels
sufficient to reduce firms' bank-loan balances to
very low levels, further moderate changes in the
spread will have. only a small impact on shortterm financing decisions. Thus, a movement
from say, 150 to 125 basis points will have much
less impact on market shares than a change from,
say, 50 to 25 basis points. A mid-1977 survey of
corporate treasurers indicated that many firms
would not consider increasing their short-term
bank borrowing until the spread fell to the 25-50
basis point range, while others would not do so
until the spread actually favored loans. 26 The
actual spread for P-2 rated paper issuers (i.e.,
marginal issuers) jumped from an average of 57
basis points in 1974:4-1975:3, to an average of
123 basis points in 1974:4-1978:2, and never fell
below 97 basis points in the latter period. The
sharp increase in the spread for these firms
coincided with the breakdown in the spreadmarket share relationship.
These considerations, together with the high
present level of the spread, seem to imply that
banks would have to reduce the spread substantially to restrict the growth of the commercialpaper share of the market. In addition, if most
potential paper issuers have already entered the
market, further increases in the spread might not
lead to any further increase in commercial paper's market share.
were completely eliminated, the prime rate
would still probably be too high for banks to
regain many loan customers from the
commercial-paper market.
For a loan to be profitable, a bank must set the
loan rate at a mark-up over its current cost of
loanable funds by enough at least to recover the
reserve-requirement costs and variable operating
costs associated with making and servicing the
loan. Banks face a current cost of funds roughly
eql1alto the interest rates on money-market
instruments,such as prime commercial paper
and large negotiable CD's. Thus any mark-up in
the prime rate over the bank cost offunds makes
it more expensive for top-rated corporations to
borrow at banks than in the paper market.
Reserve requirement costs alone represent a
mark-up of over 55 basis points at mid-1978
yields on CD's of 8.67 percent,27 Even at the
1977: I interest rate trough of 4.63 percent,
reserve-requirement costs translated into almost
30 basis points. Less complete data are available
on bank operating costs, but a recent Federal
Reserve study of a group of medium-sized banks
suggests that their variable noninterest costs for
business loans average just over 100 basis
points. 28 Given the economies of scale in banking, this estimate probably overstates the costs at
money-center banks, but suggests at least that
they are most likely substantial.
These cost factors tend to set a floor below the
rate spread, which gives most eligible corporations a substantial cost advantage in issuing
commercial paper. For reasons already discussed, nonfinancial corporations increasingly
have focused their attention on relative costs, not
bank relationships, in deciding between alternative sources of finance. Most prime-rated firms
are not willing to pay a large prime rate-paper
rate spread because they receive relatively little
value from the intangible intermediary services
offered by banks. Furthermore, many such firms
can enjoy the benefits of a sound bank relationship and take advantage of lower borrowing
costs in the paper market at the same time. For
the foreseeable future, therefore, banks probably
will not be able to lower their spreads enough to
attract substantial loan business from the
commercial-paper market. 29
However, the rate spread for corporations
Secular shift?
The remaining question concerns whether
banks will reduce their prime-rate spread enough
in the foreseeable future to regain their former
position as the major source of short-term funds
for prime-rated nonfinancial corporations. Fortunately, an answer to this question does not
require a prediction of future changes in the
spread, which depend on such difficult-toforecast factors as bank-loan portfolio risk,
growth in bank capital, and bank willingness to
make fixed-rate loans. Even if such influences
49
with less than the top commercial-paper rating
may well favor the use of bank credit during
periods of stress in the financial markets, such as
happened in 1974. During this period, several
corporations (including paper-issuing utilities
an.dREIT's) experienced difficulties, and some
giant firms (e.g., W.T. Grant) actually failed. In
response to a perceived increase in lending risks,
the spread between Prime-2 and Prime-I (30-59
day) dealer-placed paper rates averaged about
145 basis points in the 1974:3-1975: I period, and
reached a peak of 153 basis points in 1974:4.
Thus, future periods of financial stress might
lead some firms to shift from paper-market
financing to bank financing. Still, this would
most likely be a temporary phenomenon, lasting
only until prime rate-paper rate spreads returned
to more normal levels for Prime-2 firms.
IV. Conclusions and Policy .Implications
In this paper, we have argued that the
commercial-paper market has replaced the
banking sector as the primary source of shortterm funds for large, financially sound nonfinancial corporations. Banks can compete effectively
with the open-market only if the value of their
intermediary services to ultimate lenders and
borrowers is greater than the spread between the
lending and borrowing rates that they must
charge to cover the costs of doing business and
absorbing risk. We concluded that the value of
these services is relatively small for those large
corporations who are eligible to participate in
the commercial-paper market. Thus, the recent
switch from an intermediary to a direct-finance
market as a means of channeling short-term
funds between large corporations has probably
improved the efficiency of the U.S. financial
system.
What are the public-policy implications? With
prime-rated firms now a smaller factor in the
market for short-term bank loans, the riskiness
of bank-loan portfolios tends to increase, thus
exposing the banking system to greater market
risk. The probable permanence of this development should be of interest to bank regulators
when determining capital-adequacy standards
for the banks they supervise. Furthermore, this
greater risk exposure reinforces the effects of
other major postwar trends in bank balance
sheets, such as the reduction in capital cushions
and the declining ratio of low-risk security holdings to loans. At the same time, banks have come
to rely on liability management as their main
source of liquidity. Because of that factor, a
liquidity squeeze could result from policy attempts to restrict the flexibility of liability management, such as through a greater restrictiveness of Regulation Q interest-rate ceilings. 30
Competition from the commercial-paper market affects large money-center banks more than
other banks, since their typical customers are the
firms most likely to be active in the paper market.
These giant corporations, typically highly liquid,
generally have modest external financing needs
until late in cyclical expansions. Thus, business
loan activity at money-center banks is usually
sluggish until near business-cycle peaks, but then
grows rapidly. Increased corporate use of the
paper market contributed to greater-than-usual
weakness in large bank loan activity in the earlier
stages of the present recovery, and may also
mean that the spurt in loan demand may not be
as strong at the next cyclical peak as at earlier
peaks. But money-center banks still may be able
to capture some loan business from less-highly
rated paper issuers, because risk premiums in the
paper market tend to rise as financial strains
develop near the end of expansion periods. At
that point, however, reserve-requirement costs
(which are significantly higher for large than for
small banks) will widen their competitive disadvantage vis-a-vis the paper market. These costs
vary positively with market interest rates, and
will thus be at their highest point in the stage of
the cycle when large banks might otherwise be
able to capture some short-term loan business
from the paper market.
The low sensitivity of paper-market borrowing to the prime rate-paper rate spread implies a
similar low sensitivity of business-loan demand.
The use of past statistical relationships (which
include the rate spread as an explanatory variable) to forecast business-loan movements might
well produce misleading results, at least until
enough time has elapsed to estimate new demand
relationships. However, business loans may be a
50
Indeed,according to a large body of economic
literature, the scope of financial intermediaries
has expanded relative to direct finance markets
as the economy has become more complex and
specialized. In this paper, however, we have
pointed out one case in which the process has
been reversed, with the scope of the commercialpaper market increasing relative to that of large
commercial banks.
more useful business-cycle indicator than in the
past, since loan movements over the cycle will
probably not be significantly affected by changes
in the prime rate-paper rate spread. Thus, the
correlation between loans and business spending
(and thus the business cycle) may be stronger
than in the past.
Innovations in institutional arrangements are
not uncommon events in financial markets.
FOOTNOTES
8.. See Moody's Investors' Service, Moody's Bank
Survey (March 6,1978), pp. 1539-1542.
1. See Jack Beebe. "A Perspective on Liability Management and Bank Risk", Economic Review, Federal
Reserve Bank of San Francisco, Winter 1977, pp. 12-25.
9. Several other somewhat less important cost considerations also affect the choice between commercialpaper market and commercial-bank financing. Additional costs associated with issuing paper are the 1/8 of
a percentage point dealer fee, fees to money-marketban.k agents for handling the collection and payment of
commercial-paper transactions, and fees to
commercial-paper rating agencies. On the other hand,
banks generally require higher compensating balances
for loans than for lines-of-credit necessary to back-up
commercial paper outstanding. Moreover, expected
prime-rate changes can influence the effective cost of
bank borrowing, since rates charged on existing loans
often fluctuate with the current prime rate.
2. This section draws heavily on John G. Gurley and
Edward S. Shaw, "Financial Intermediaries and the
Savings-Investment Process," Journal of Finance (May
1956), pp. 257-66, and James C. VanHorne, "The Functions of Financial Markets," Functions and Analysis of
Capital Market Rates (Englewood Cliffs, New Jersey:
Prentice-Hall, Inc., 1970), pp.1-14.
3. See Evelyn M. Hurley, "The Commercial Paper
Market", Federal Reserve Bulletin, (June 1977), pp. 525536 for information on current commercial paper market institutions. For a discussion of earlier institutions
and behavior see Nevins D. Baxter, The Commercial
Paper Market (The Bankers' Publishing Company, Boston, 1966), and Frederick C. Shadrack, Jr., "Demand
and Supply in the Commercial Paper Market", Journal
of Finance (September 1970), pp. 837-857.
10. This spread did, however, become significantly
negative in 1973-74 (averaging -32 basis points) as
banks competed aggressively for funds in the CD
market during this "tight" money period (see chart 2).
4. Three rating services actively rate commercial paper
at present. Moody's Investors Service rated over 80
percent of the 714 commercial-paper issuers at the end
of 1976. Standard & Poor's Corporation also rated a
large number of commercial-paper issuers, while Fitch
Investors' Service rated less than 60 issuers in late 1976.
Most dealer-placed commercial paper now has ratings
from at least two of these services because of a Securities and Exchange Commission ruling, effective July,
1977, which requires that dealers who take commercial
paper with less than two ratings into inventory must
"write-down" the value of that paper by from 15 to 30
percent.
Rates are set at a small mark-up over the banks' marginal cost of fu'nds, and are thus below the prime rate but
still above prime commercial-paper rates. These loan
programs appear to be designed to complement (rather
than compete with) the paper market, and to compete
with other banks, by providing a service to paper
issuers when the paper market is temporarily congested. Two of the banks have stated that the desired
volume of such lending is small, since the loans are not
particularly profitable (if at all) to them.
11. For example, assume the following structural
model:
CPs = a(RP-RCP) + bX
CPd = c(RCP-RCD) + dZ
where CPs supply of commercial paper outstanding
CPd = demand for commercial paper outstanding
RP,RCP, RCD = yields defined in text,
X, Z = other explanatory variables.
5. Bank holding companies are the other significant
issuers of directly-placed commercial paper, and they
also issue a small amount of dealer-placed paper.
6. Other issuers in the dealer-placed market include
smaller finance companies, bank holding companies,
mortgage companies, real-estate investment trusts,
and firms engaged in transportation, insurance and
leasing.
The corresponding reduced form equation for CP is:
7. These 160 banks, wh ich are part of the Federal
Reserve Board's large weekly reporting bank sample,
have a larger average size than the other banks in the
full sample. The business loans of the selected banks
represented over 82 percent of all such loans of the full
sample in December 1977. See Board of Governors of
the Federal Reserve System, Statistical Releases H.12
and H,12(B). These data were seasonally adjusted by an
X-11 procedure for use in this article.
CP =
~ (RP - RCD) + ~ X + ~ Z.
a+c
a+c
a+c
12. As discussed on page 43, this involves using the
short-term commercial and industrial loans of selected
large weekly reporting banks.
13. See Nevins D. Baxter, The Commercial Paper Market, The Bankers' Publishing Company, 1966.
51
14. Morgan Guaranty Trust Company, "The New Dynamics of the Market for Business Credit", The Morgan
Guaranty Survey (March 1978), pp. 6-11.
fifilse.rve System, "Survey of Terms of Bank Lending",
Statistical Release G.14. This information first became
available in February 1977.
15. See Nevins D. Baxter, The Commercial Paper Market,Op.cit.
23. Two other factors have also probably had an important influence on the spread-decreases in reserve
requirement costs, and increases in other non-interest
bank operating costs. (See Federal. Reserve System's
FUnctional Cost Analysis>. These factors are not emphasized!n the text for three reasons. First, information
on the quantitative changes in operating costs is scanty.Second, the two effects have tended to offset each
othfilrduring the period in question. Third, other explanations of the increased prime-rate spread appear to
be sufficient.
16. Frederick C. Shadrack and Frederick S. Breimyer,
"fiecem Q.evelopments in the Commercial Paper Markef',M'onthlyReview, Federal Reserve Bank of New
York, December 1970, pp. 280-291.
17. It should be noted, however, that in June 1970, the
credit "crunch"-induced boom in commercial paper
was abruptly but temporarily halted when the Penn
Central Transportation Company defaulted on its $82
million of commercial paper outstanding. The Federal
Reserve acted quickly in the ensuing crisis, making a
large volume of loans to commercial banks through its
"discount window", and raising Regulation Q interestrateceHings on 30-89-day large negotiable certificates
of deposit. These actions accomodated banks in making loans to credit-worthy customers affected by the
crisis. Thus the precipitous decline in nonfinancial
commercial paper outstanding lasted only three weeks.
However, investors remained extremely selective regarding commercial-paper issuers at least through the
end of 1970, and thus tended to retard the growth of
commercial paper relative to bank loans.
24. This spread may have been reduced, in part, due to
competition from U.S. offices of foreign banks. See
Board of Governors of the Federal Reserve System,
"The Recent Growth in Activities of U.S. Offices of
Foreign Banks, Federal Reserve Bulletin, October 1976,
pp. 815-823.
25. Robert B. Albertson, "Loan Demand Survey Forecasts Continued Uptrend in Business Loans,"
Research: Banks (Smith, Barney, Harris, Upham and
Co., Inc., October 26, 1977>' See George M. Salem,
"Bank Commercial Loan Demand-An Analysis of
Secular Trends," Institutional Research, (Bache, Halsey, Stuart, Shields, Inc. October 6, 1978), for an analysis of how commercial paper, U.S. offices of foreign
banks, corporate liquidity and other factors have affected secular developments in business-loan demand at
large money-center banks.
18. In order to counteract potential political pressures
against future prime-rate increases, First National City
Bank (now Citibank) formally instituted, in October
1971, a formula approach, which explicitly tied the
prime rate to a measure of the market cost of funds. The
original Citibank formula set the prime for any given
week at 50 basis points above a moving average of the
90-119 day dealer-placed paper rates over the previous
three weeks. The result of this formula was then
rounded to the nearest 25 basis-point increment to
determine the prime rate. Most large banks adopted this
formula or a similar one by the end of 1971. The formula
mark-up has been changed a number of times since
1971, and presently stands at 125 basis points. It has
served as only a rough guide for prime-rate changes,
however, with the largest departures from the formula
occurring during periods of rapid changes in market
interest rates such as 1973-74. See Murray E. Pollakoff
and Morris Budin, The Prime Rate, Trustees of the
Banking Research Fund, Association of Reserve City
Bankers, 1973.
26. George M. Salem, "Bank Loan Demand: Competition from Commercial Paper Increasing", Banking Industry Comment,(Reynolds Securities, July 21, 1977>'
27. With the current 6-percent reserve requirement on
large negotiable CD's, only 94 percent of funds obtained can be loaned out. Thus, with the CD rate at 8.67
percent, the market cost of funds per dollar loaned
equals 8.67 + .94 = 9.22 percent, implying a reserve
requirement cost of 9.22-8.67=.55 percent.
28. Federal Reserve Bank of San Francisco, 1977 Functional •Cost Analysis Special Report: National Billion
Dollar Banks, 1978.
29. Three large banks have recently initiated loan programs available to some, but not all, customers with
bank credit lines to back commercial paper issues.
Rates are set at a small mark-up over the banks' marginal cClst of funds, and are thus below the prime rate but
still above prime commercial-paper rates. These loan
programs appear to be designed to complement (rather
than compete with) the paper market, and to compete
with other banks, by providing a service to paper
issuers when the paper market is temporarily congested. Two of the banks have stated that the desired
volume of such lending is small, since the loans are not
particularly profitable (if at all) to them.
19. For another discussion of these prime-rate increases, see Randall C. Merris, "The Prime Rate Revisited",Economic Perspectives (Federal Reserve Bank of
Chicago, July/August 1977), pp. 17-20.
20. See Federal Deposit Insurance Corporation, Annual
Report (1976), pp. 245-259.
21. See Federal Deposit Insurance Corporation, Annual
Report (various years). Also see Jack Beebe, "A Perspective on Liability Management and Bank Risk," op.
cit., for an analysis of bank capital positioning during
this period.
30. This policy implication is developed by Jack Beebe
in "A Perspective on Liability Management and Bank
Risk," op. cit.
22. These data were obtained from a sample of 48 large
banks reported in Board of Governors of the Federal
52
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53
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