COMMITTEE ON FINANCE, INVESTMENT BANKERS ASSOCIATION OF AMERICA, GENTLEMEN: We are filing this supplementary statement to emphasize certain major points made in our testimony on September 24, 1969, and to challenge directly certain contrary assertions made before your committee the following day by former Assistant Secretary Stanley S. Surrey. These assertions deal largely with the market and investment impact of those sections of H.R. 13270 which concern the tax treatment of State and local bond interest. Mr. Surrey's statements, which we believe to be in error, include: (1) An insistence on the claim that the Treasury would gain if State and local financing was shifted to the taxable market, and (2) An attempt to downgrade the adverse effect, both actual and potential, of H.R. 13270 on the municipal bond market. Concerning the first point, Mr. Surrey claims: "Now the Secretary of the Treasury could pay close to 50% of the interest on State and local bonds and the Federal Government would not lose anything on the matter." On questioning, he admitted that this statement was based on calculations by "others more expert on this than I." We are familiar with the studies to which he refers, and note for the record that they were made several years ago, and also that they were deficient in that they did not deal with the resulting major shifts in all capital markets and major economic side effects such as across-the-board rises in long-term interest rates. In our initial testimony, we described the up-to-the-minute study of this matter made under the direction of Dr. Sally S. Ronk, well known as an authority on the flow of funds in the capital markets, and based on the results of a questionnaire which the Investment Bankers Association directed to portfolio managers and investment advisors of major financial institutions in late August. Mr. Surrey's statement that the Treasury could afford to subsidize the State and local goverenments up to 45 per cent or even 50 per cent of the interest cost on their taxable bond issues and still not lose any money, assumes that the present buyers of tax-exempt bonds would be forced to buy taxable obligations (or the equivalent) to the same degree they previously bought tax-exempt. This assumption is not realistic. The Investment Bankers Association study makes a number of points: (1) Investors will probably not acquire taxable municipal bonds to the same extent as formerly. They will surely place some funds in other categories of investment. (2) Furthermore the investors likely to be most interested in the proposed new taxable municipal bonds are pension funds and savings institutions, who either pay no taxes or are in relatively low brackets and individuals in the lower income brackets. Business corporations and commercial banks, on the other hand, are more heavily taxed; they and high-income individuals would surely be attracted much less to the new bonds than they are today to the tax exempts. (3) The resultant shifts in acquisitions and new issues among holders in various tax brackets would lower the average marginal tax rate on all fixed-income issues acquired. This means that the increase in tax rates to the Treasury would be substantially less than the 45-50 per cent Federal Government subsidy, and indeed would be less than the 40% subsidy permitted by H.R. 13270. The Treasury would be a net loser. (4) Thus, it would become more difficult to place the new taxable municipal bonds and since they would compete with corporate bonds, Treasury and Federal agency bonds, and mortgages, the result would be to drive interest rates higher and interest costs would rise for all borrowers, the Treasury, Federal Agencies, Corporations, and home owner mortgages. In sum, after taking into account all capital market shifts and economic side effects, the IBA concluded that, even if the Treasury were to subsidize the interest cost of States and municipalities by no more than 32 per cent, the net loss to the Treasury would be $66 million, and to all governments $114 million, on each year's financing. And if the Treasury should subsidize at 40 per cent of the interest cost as permitted in H.R. 13270, the net loss would be $115 million for the Treasury and $163 million for all governments. These figures are for each year's financing and would accumulate year after year. With respect to market impact, Mr. Surrey argues that inclusion of tax-exempt bond interest in the limit on tax preferences and the allocation of deductions will have only a modest impact on the holders of tax-exempt bonds, and from this concludes that the eventual market impact should also be modest. He is either unaware or unwilling to admit that the market regards a small encroachment on tax exemption as only a first step rather than the final step. In our initial testimony we pointed out that there is no such thing as a limited exposure of municipal bonds Federal Taxation, and we indicated the reasons why. The market has already reflected this in a substantial rise in the cost of local borrowing. There has been a corresponding decline in the market value of outstanding municipals, and we now present additional information on this point. THE IMPACT OF TAX REFORM PROPOSALS ON OUTSTANDING BONDS In order to estimate the impact of tax reform proposals on outstanding state and municipal bonds, it was necessary to reconstruct a model amortization schedule based on assumptions derived from recent research. From Dr. Reuben Kessel's studies, it was known that the general obligations have an average life of 14 years and the revenue bonds an average life of 21 years, that the quality of general obligation bonds' averages out to approximately a Moody's "A-1" and the quality of revenue bonds to about a Moody's "A", that revenue bonds yield approximately 10 basis points more than general obligation bonds of the same quality and maturity. From Bond Buyer data it was known that outstanding bonds consist of approximately 60% general obligation bonds and 40% revenue bonds. On the assumption that all such bonds were being amortized on a level debt service basis (an assumption which tends to over extend somewhat the retirement of general obligation bonds), a model amortization schedule was developed which corresponds with all the other known characteristics of the outstanding bonds. (See Exhibit A attached.) The two separate portions of the outstanding market, i.e. an average 14-year Moody's A-1 3.45% general obligation bond and an average 21-year Moody's "A" 3.55% revenue bond were valued as of early-January 1969 and again as of October 1, 1969 to determine the price deterioration during this period. The results are as follows: During the period January 1 to October 1, 1969, yields generally increased, as measured by representative indexes-the Bond Buyer's 20-bond index, White's Value of 100 and Moody's "Aa" average-about 150 basis points, of which we ascribe between 3 and 1⁄2 to the negative effects of tax reform proposals and the remainder to the effects of inflation and Federal Reserve tight money policies. On this basis, outstanding State and local bonds are estimated to have suffered overall market damage of between $5.9 billion and $8.8 billion as the result of tax reform proposals. *Bank Underwriting of Revenue Bonds. Hearings before the Subcommittee on Financial Institutions of the Committee on Banking and Currency, United States Senate, Ninetieth Congress, First Session, on S. 1306. U.S. Government Printing Office; Washington, 1967, pp. 192, 195. DAMAGE NOW, WINDFALL (?) LATER Mr. Surrey justifies subjecting existing securities to the limit on tax preference and the allocation of deductions proposals, because this is "only a mild offset to the windfall gains that are involved if tax-exempt securities tend to be smaller and smaller in proportion to the volume of taxables outstandings." Translated, this means that the Federal Government is justified in inflicting a sure loss on existing bondholders now because they might be benefitted at some distant date in the future if a highly controversial scheme for issuing taxable municipals is adopted, if it turns out to be workable, and if interest rates do not further deteriorate. With over $130 billion now outstanding, and with nearly $75 billion of these due to remain outstanding fifteen years from now, as shown in Exhibit A, "windfall gains" owing to scarcity seem a long way off. LEBENTHAL & CO. INC., SURVEY We have important new evidence as to the reaction of the individual investor to the direct and indirect taxes imposed by the limited tax preference proposal and allocation of deductions proposal embodied in H.R. 13270. On September 5, 1969, Lebenthal & Co., Inc., of New York City, a municipal dealer firm specializing in municipal bonds for the individual investor, mailed its own questionnaire to 6,500 individual owners and prospective owners of municipal bonds. 770 replies were received by Lebenthal in the one week September 9th through September 16th. Lebenthal's questionnaire and its analysis of the results are set forth in Appendix A. Among the more important conclusions of the Lebenthal survey are the following: 1. The answer to Question 6 of the survey indicates that 72% of the sample received less than $10,000 per year in tax-preference items and hence would be unaffected by either the limit on tax preferences or the allocation of deductions. 28% would presumably be affected by the allocation of deductions proposal. As indicated in our previous testimony to the Committee, this is a substantial portion of individuals who would be affected by the allocation of deductions proposal and a much greater portion than would be affected by the limited tax preferences proposal. The Lebenthal survey indicates that only 5% of the sample would be hit by the limited tax preferences proposal. 2. H.R. 13270 would severely damage the individual share of the present market for tax-exempt bonds. 56% of those answering yes or no to Question 7 (42% of the total sample) indicated they would not be willing to invest in municipal bonds even though they were not personally affected by the bill, i.e., their total tax-free income did not exceed $10,000. This was further substantiated by the answers to Question 6, which demonstrated that the tax-free feature of municipal bonds was far and away from their most attractive feature. 3. The answers to Question 9 indicate clearly that substantially higher interest rates will be required on taxable municipals than are presently available on comparable corporate bonds. Furthermore, the response to Question 11 indicates that the smaller non-rated communities and the big cities with difficult social and economic problems will suffer the most severely. Although investors are willing to buy such bonds as tax-exempt, they are unwilling to buy them as taxable securities except at prohibitive rates. Incidentally, preliminary results of an extensive IBA research study presently being conducted by Robert King, Research Director of IBA, indicate that smaller non-rated communities receive satisfactory treatment as to interest costs under the present system, and apparently have few borrowing problems. Respectfully submitted on behalf of Municipal Securities Committee, Investment Bankers Association. PAUL S. TRACY, Jr., Chairman, Municipal Special Committee on Basic Research, Investment Bankers Association. *The Lebenthal Survey appears elsewhere in this hearing. EXHIBIT A MODEL AMORTIZATION SCHEDULE FOR $127,200,000,000 PAR VALUE MUNICIPAL BONDS 1 1 $127,200,000,000 represents the average gross outstanding State and local government long-term debt in 1968, The CHAIRMAN. Now, I would like to call Hon. Jack Williams, Governor of Arizona. Governor, we are pleased to have you here. Senator Fannin is a member of this committee and, as Senator Williams pointed out, he is engaged with the other Republicans and in a caucus they are holding today in order to elect their Republican leader of the Senate. It might be a close vote so I am sure he would want to be there, and you can understand his absence at this particular moment, I am sure. STATEMENT OF HON. JACK WILLIAMS, GOVERNOR, STATE OF ARIZONA; ACCOMPANIED BY THOMAS F. ALLT, MAYOR, YUMA, ARIZ.; AND BUD TIMS, MAYOR, SCOTTSDALE, ARIZ. Governor WILLIAMS. Thank you very much, Senator Long. I have with me two mayors of the towns of Arizona for very brief statements, and I will brief mine. One is Mr. Bud Tims, of Scottsdale, Ariz. The other is Mayor Thomas Allt, of Yuma, Ariz. Also in the audience I have Joe Refsnes, Jr., and Fred Rosenfeld for any technical matters I might run into. My name is Jack Williams and I am Governor of the State of Arizona. As a Governor I am most concerned with the impact of certain provisions of the Tax Reform Act of 1969. Arizona is one of the fastest growing States in the Nation in terms of population. Many new families move into the State every day. Additionally, new businesses are developing within the State and many manufacturers have seen fit to locate additional facilities in Arizona. We welcome these individuals and firms to share our vision of the good life and the future of our State. However, their arrival creates a demand for additional public facilities and services. In Arizona, as in many States, such major public facilities cannot be constructed on a "pay as you go" basis. Existing operating revenues of the school districts, the cities, the counties and the State are not sufficient to permit this. Nor, if the example of major private enterprise may be taken as a guide, would this be sound management practice. Good financial management seems to involve the option in certain instances of borrowing to construct facilities as needs arise, and amortization of construction costs over a period of years. Governments in Arizona can become indebted-can borrow money-only through the issuance of bonds. The provisions of H.R. 13270 will have a substantial impact on the marketability and costs of municipal bonds. The interest subsidy program proposed under this legislation, in our view, is "Too little, too late" an poses a number of problems, some of which go to the very heart of our federal system. Two provisions of H.R. 13270, the allocation of deductions rule, and the limit on tax preference, will have the net effect of placing a tax on municipal bond interest. We are advised that there are some constitutional questions surrounding this matter. It may be assumed that the constitutionality of this measure will be challenged in the court, resulting in lengthy litigation. During this time, the tax status of municipal bonds will be unclear and investors will be either unwilling to invest in these bonds, or will demand high enough interest rates to protect themselves against taxation. Turning aside for the moment from the question of the cost and marketability of municipal bonds, legislation of this nature could create an inequitable situation in which bond investors may reap a substantial windfall at the expense of local property taxpayers. If investors demand interest rates sufficient to offset possible taxation, and such taxation is later declared unconstitutional, those individuals. who purchase municipal bonds will be receiving interest payments at a rate which would normally apply to taxable securities. Yet those payments will be nontaxable, thus resulting in a substantial gain for the investor. Needless to say, this windfall will be subsidized by local taxpayers across the Nation. As I indicated a moment ago, there are serious questions about the marketability of a taxable municipal bond. This is, in effect, a new form of security, and certainly will be in competition with corporate bonds. In the case of States, larger cities, and some urban counties and large school districts, the competition will be between municipal securities and top-rated corporate bonds. In our smaller cities, counties, and school districts, however, and we have many of them in a small State, the competition will be between municipal bonds and second |