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The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the Bank’s Research and Public Information Department under the supervision of Michael W. Reran, Senior Vice President. The publication is edited by William Burke, with the assistance of Karen Rusk (editorial) and William Rosenthal (graphics). For free copies of this and other Federal Reserve publications, write or phone the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 544-2184. 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 REFERENCES Merris, Randall C., "The Prime Rate Revisited", Economic Perspectives, Federal Reserve Bank of Chicago, July/August 1977, pp. 17-20. Morgan Guarantee Trust Company, "The New Dynamics of the Market for Business Credit", The Morgan Guarantee Survey, March .1978,pp.6-11. Polakoff, Murray E., and Morris Budin, The Prime Rate, Trustees.ofthe Banking Research Fund of the Association of Reserve City Bankers, 1973. Pyle, David H., "Descriptive Theories of Financial.lnstiMionsUnder Uncertainty", Journal ·01 Financial and Quantitative Analysis, Decernber 1972, pp. 20C9-2029. Pyle, David H., "On the Theory of FinanciaUntermediation", Journal of Finance, June 1971, pp. 737-61. Salem, George M., "Bank loan Demand: Competition from Commercial Paper Increasing", Banking Industry •Commlmt, Reynolds Securities, July 21, 1977. Salem, George M., "Commercial Bank loan Dernand..... An Analysis of Secular Trends", InstitutionlllResearch, Basche Halsey Stuart Shields Inc., October 6,1978. Schad rack, Federick C., and Frederick S. 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