ECONOMICS, STATISTICS, AND COOPERATIVES SERVICE • U.S. DEPARTMENT OF AGRICULTURE

' Page

1 t6

Texas Cattle Feedlots

Issues Related to Entry of Young People into Farming

1 J lm pact of Welfare Reform on Rural Areas

21 Cost of Capital for American Agriculture:

Its Use in Agricultural Policy Formulation

VOLUME 38/MAY 1978

29 Identifying Growth Potential of Locally Owned Farmer Cooperatives

J5 The Effects of Multibank Holding Company Acquisitions on

Rural Banking

4J Real Estate Seller Financing and Tax Management:

A Profitability Analysis

51 News Notes

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FOREWORD

The Agricultural Finance Review is an annual publication produced by the Economics, Statistics, and Cooperatives Service.* Articles report on concepts and research in a broad range of agricultural finance issues that relate to farm and rural finance; financial manage­ment and firm growth strategies; insurance; income; farm supplies, processing, and distri­bution industries; financial institutions; taxation; rural economic development; and the organization of agricultural production. The Review is a collection of contributed articles which are presented in a nonmathematical, nontechnical manner to make them accessible to the widest possible audience. The current volume was compiled by David A. Lins and Philip T. Allen.

The next issue of Agricultural Finance Review will be a special issue devoted strictly to policy issues in agricultural finance. Invited articles on selected policy issues will be included. Other articles will be considered if they relate to important policy issues in agricultural finance.

Manuscripts and editorial correspondence relating to the Review should be addressed to Philip T. Allen, Economics, Statistics, Cooperatives Service, Room 120, 500 12th St., S.W., U.S. Department of Agriculture, Washington, D.C. 20250, or to David A. Lins, Economics, Statistics, and Cooperatives Service, 305 Mumford Hall, University ()f Illinois, Urbana, Illinois 6180 I. Manuscripts should be submitted in duplicate and should not exceed 20 pages, including tables, footnotes, and references. Manuscripts should be double spaced with tables and figures on separate pages. Number footnotes consecutively throughout the manuscript and list them on a separate page after the text. Please state in a cover letter why your manuscript would be of interest to the readers of the Review, and indicate whether the material has been published elsewhere.

*On January 1, 1978, three USDA agencies-the Economic Research Service, the Statistical Reporting Service, and the Farmer Cooperative Service-merged into a new organization, the Eco­nomics, Statistics, and Cooperatives Service.

Publication of conclusiom and viewpoints expressed by the authors does not necessarily represent an endorsement by the U.S. Department of Agriculture. Articles may be quoted, reprinted, or abstracted without authorization; however, citation is appreciated. Comments from readers are welcomed.

CONTENTS

Articles Page

Texas Cattle Feedlots ........................................... . Raymond A. Dietrich, Donald R. Levi, and J. R. Martin

Issues Related to Entry of Young People into Farming. . . . . . . . . . . . . . . . . . . . . . 6 J. Bruce Hottel and Peter J. Barry

Impact of Welfare Reform on Rural Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Thomas A. Carlin and linda M. Ghelfi

Cost of Capital for American Agriculture: Its Use in Agricultural Policy Formulation . 21 Fred C. White, Wesley N. Musser, and Johannes Oosthuizen

Identifying Growth Potential of Locally Owned Farmer Cooperatives . . . . . . . . . . . . 29 Gary T. Devino, Francis P. McCamley, and Stephen E. Mathis

The Effects of Multibank Holding Company Acquisitions on Rural Banking. . . . . . . . 35 Warren F. Lee and Alan K. Reichert

Real Estate Seller Financing and Tax Management: A Profitability Analysis . . . . . . . . 43 Peter J. Barry and Donald R. Levi

News Notes

Farmers Home Administration's New Unified Management Information System . . . . . 51 Roy E. Battles and Harold K. Street

New Survey of Terms of Bank Lending to Farmers . . . . . . . . . . . . . . . . . . . . . . . . 53 Emanuel Melichar

Federal Farm Credit Banks Consolidated Systemwide Bond. . . . . . . . . . . . . . . . . . . 57 Darrell M. Johnson and George D. Irwin

Reports on Foreign Investment in the United States. . . . . . . . . . . . . . . . . . . . . . . . 59 Kenneth R. Krause

Texas Cattle Feedlots

Raymond A. Dietrich, Donald R. Levi, and J.R. Martin I

With the advent of large commercial feedlots during the sixties, cattle feeding became "big business," requir­ing sophisticated management techniques not only in feeding and marketing cattle, but also in acquiring the necessary capital for either maintaining or expanding feedlot operations. Increasing numbers and growing sizes of large commercial cattle feedlot operations during the last decade brought about greater demand for various resource inputs, including operating and long-term capi­tal (J, 2).

limited partnership arrangements in cattle feeding, commonly referred to as cattle feeding funds, achieved prominence in the cattle feeding industry during the late sixties and early seventies (3, 4, 5). 2 Cattle feeding funds were an outgrowth of rapidly expanding capital needs of large-scale commercial cattle feeding firms. Some of these firms attempted to raise equity capital, merchan­dise management and feedlot services, and/or maintain feedlot utilization rates at optimum levels through limited partnership arrangements.

The use of limited partnership arrangements is primarily related to the fact that these arrangements pro­vide three important investor objectives: limited lia-

bility, passage of income tax treatment, and title market­ability.

Since subscribers to such cattle feeding funds are mostly individuals with relatively high incomes, questions have been raised as to whether such investments are motivated by the income-generating ability of funds or by the tax deferral and tax management mechanisms afforded by limited partnership arrangements. There is also some concern about the economic and legal impli­cations for the cattle feeding industry in view of the effects that the 1976 law might have on limited partner­ship arrangements. This report addresses these questions.

Data presented for the organizational and structural characteristics of limited partnerships in cattle feeding were obtained from the various prospectuses filed with the Texas State Securities Board from 1972-74. Data concerning the socioeconomic profile of investors in Texas cattle feeding funds and related information deal­ing with investment strategies and criteria of limited partners were obtained from a mail questionnaire to I ,634 fund investors throughout the United States during 1972-74. Total usable returned questionnaires represented 26 percent of the investors sampled.'

MAJOR CHARACTERISTICS OF TEXAS CATTLE FEEDING FUNDS

More than one-half of the 33 limited partnership prospectuses examined for the 1972-74 period were organized specifically for feeding cattle, another one-

1 Dietrich and Levi are associate professor and professor, respectively, the Texas Agricultural Experiment Station and Department of Agricultural Economics, Texas A&M Univ., College Station, Tex. Martin is an agricultural economist, U.S. Department of Agriculture, Economics, Statistics, and Coopera­tives Service, Tex. A&M Univ., College Station, Tex.

2 Limited partnerships and cattle feeding funds are not always synonymous. Limited partnerships may be involved in any enterprise, particularly those using outside investor capital. Cattle feeding funds may be created using other forms of busi­ness organization. However, because most cattle feeding funds are organized as limited partnerships, the terms are used inter­changeably in this article.

third provided provisions for raising cattle prior to feed­lot placement, and the remainder involved cattle breed­ing, cattle raising, and cattle feeding.

Most of the prospectuses were organized such that a series of partnerships could be offered under one regis­tration. The average life of a fund was about 6 years. The maximum amount of capital specified by any one of the registrants ranged between $500,000 and $20 million, but most were in the $5 million to $10 million range. The general partners, on the average, leveraged this capital by borrowing about $3 from financial insti­tutions for each $1 of capital supplied by cattle feeding

3 Details concerning the sample design and other informa­tion presented in this paper are available in Texas Agr. Exp. Sta. Bul., B-1175, Jan. 1977.

funds. However, leverage ratios specified in the prospec­tuses ranged between $2 and $4 of debt capital for every $1 of equity capital.

Total cost of raising capital through these limited partnership offerings approached 8 to I 0 percent of the capital raised and was borne by the limited partners upon activation of a partnership. Most partnerships were not activated unless subscriptions equivalent to $250,000 or more were sold by a prescribed date. Three-fourths of the prospectuses specified minimum initial unit subscrip­tion prices of $5,000 with additional subscriptions in increments of $1 ,000.

Guidelines of the Texas State Securities Board specify

that limited partnership investors meet either minimum income or net worth criteria. • These requirements, as reflected in the various prospectuses, generally stipulate that investors must have either a net worth of $100,000 or more, exclusive of home furnishings and personal automobiles, or a combined net worth of $50,000 and a taxable income subject to a Federal income tax of 39 percent or more. Other components of the cattle feeding funds specified in most prospectuses include specific terms of offerings and use of proceeds, statements about the high risks in cattle feeding, cash distribution policies, withdrawal provisions, and policies concerning remune­ration and dissolution.

SOCIOECONOMIC PROFILE OF FUND INVESTORS

Age and Income

During 1972-74, investors in Texas cattle feeding funds averaged about 50 years of age with an average annual gross income in excess of $80,000 (tables I and 2). Two-thirds of the fund investors ranged in age from 45 to 64 years and another 22 percent were in the 35 to 44 age group. The proportion of investors less than 35 years and over 65 years was relatively small since annual discretionary incomes for this group were generally not as high as the 35 to 64 age group. Additionally, the suit­ability requirements of most funds were often too high for investors under 35 years old.

Although the estimated annual average gross income of all cattle fund investors surveyed was in excess of $80,000, more than 40 percent of the fund subscribers reported annual gross incomes varying from $40,000 to $79,000 (table 2). The second highest income range was the $80,000 to $119,999 group, followed by the under

Table 1-Age ranges of subscribers to Texas cattle feeding funds, 1972-7 4

Age

Under 25 ............... . 25-34 ................. . 35.44 ................. . 45.54 ................. . 55-64 ................. . 65 and over ............. .

Percent

0.2 4.7

22.3 38.1 27.0

7.7

Table 2-Average annual gross income of Texas cattle feeding fund investors, 1972-74

Annual gross income

Under $40,000 ........... . $40,000. $79,999 ........ . $80,000- $119,999 ....... . $120,000. $159,999 ...... . $160,000. $199,999 ...... . $200,000 and over ........ .

2

Percent of investors

16.8 43.8 24.2

7.1 2.1 5.9

$40,000 group. More than 15 percent of the investors reported annual gross incomes in excess of $I 20,000.

Primary Occupations

More than 90 percent of the cattle feeding fund investors in Texas feedlots during 1972-74 had occupa­tions outside the agricultural field (table 3). The primary occupation held by almost 20 percent of the fund investors was physician/dentist, followed by engineer/ contractor, then executive/manager. Other primary occupations included banker /investor, attorney, retired individual, salesperson, and farmer/rancher.

Table 3-Primary occupation of cattle feeding fund investors, Texas feedlots, 1972-74

Primary occupation

Physician/dentist ......... . Engineer/contractor ....... . Executive/manager ........ . Banker/broker/investor .... . Attorney ............... . Retired individual ......... . Salesperson (including

car salesperson) ......... . Farmer/rancher .......... . Manufacturer ............ . Housewife/self-employed ... . Realtor ................. . Scientist ................ . I nsu ranee agent .......... . Cattle feedlot owner ....... . Other' ................. .

Percent

19.3 9.8 8.6 7.0 5.9 5.9

5.7 5.5 4.3 2.7 2.3 1.8 1.8 1.6

17.8

1 Included are such occupations as merchandiser, publisher, advertiser, restaurant operator, fisherman or seaman, home fur­nisher and plumber, architect, teacher and university administra­tor, entertainer, accountant, trucker, quarryman, and nursery­man all of which accounted for 1.5 percent or less per occupa­tional category.

• Many other Stales, particularly those belonging to the Midwest Securities Commissioners' Association, follow similar guidelines.

INVESTMENT CRITERIA

In order to gain insight into the incentives or motives for investments in cattle feeding funds, subscribers were asked to rank the investment criteria from I to 5 speci­fied in table 4, with I receiving the highest rank of im­portance. "Tax deferral incentive" was ranked first by 63 percent of the respondents; "potential return on investment" was ranked first by another 31 percent.

Ranking of primary investment criteria in cattle feed­ing funds by income level in table 4 reveals two distinct patterns. First, tax deferral incentives became more im­portant as income levels increased. More than 86 percent of the respondents in the $200,000 and over annual

gross income level revealed that tax deferrals were a pri­mary investment incentive, compared with 43 percent of the respondents in the lowest annual gross income level or under $40,000.

Second, potential return on investment was the most important primary incentive for investors in the lowest income level, whereas it was relatively unimportant for almost all cattle feeding fund investors in the highest annual gross income level. Other investment criteria including "limited liability," "ability to pool capital," and "enjoy feeding cattle," regardless of income level, received only minimal support as a primary criteria.

Table 4-Primary investment criteria, by income, of Texas cattle feeding fund investors, 1972-74

Potential return Ability to Tax deferral Enjoy feeding Limited Annual gross income range on investment pool cap ita I incentive cattle liability

Percent

Under $40,000 ........................ 48.2 3.6 42.8 3.6 1.8 $40,000- $79,999 ..................... 29.5 ( l) 65.5 1.4 3.6 $80,000. $119,999 ..................... 28.7 3.8 65.0 (I) 2.5 $120,000- $159,999 ................... 17.6 (' ) 76.5 (I ) 5.9 $160,000- $199,999 ••••••••••• 0. 0 ••••• 16.7 (I ) 83.3 (I) (I)

$200,000 and over ..................... 6.7 (') 86.6 (I ) 6.7

Average ............................ 30.7 1.6 63.2 1.3 3.2

1 None reported by respondents surveyed.

INVESTMENT ADVISERS

Almost 60 percent of the investors in cattle feeding funds relied on investment advice from stockbrokers before investing in cattle feeding limited partnership arrangements. Although some subscribers in cattle feeding funds relied on more than one investment adviser, both financial investment firms and certified public accountants were used by about one-fifth of the subscribers. Other investment advisers included attorneys

and bankers, although more than I 0 percent of the cattle feeding fund investors did not rely on investment advice before investing in feeding funds.

More than 68 percent of the cattle feeding fund sub­scribers had invested in limited partnership arrangements other than cattle feeding. Limited partnerships in real estate and oil and gas were the predominant noncattle feeding funds favored by cattle feeding fund subscribers.

ECONOMIC AND LEGAL IMPLICATIONS

Large-scale commercial cattle feedlot firms often face problems in obtaining an adequate and dependable source of working capital from financial institutions and other sources (2). Consequently, large commercial feed­lot firms have developed alternative capital sources, such as custom feeding, which have been important in terms of the growth, development, and operation of these large feedlots. The development of limited partnerships in cattle feeding in the late sixties and early seventies pro­vided feedlots with another important source of capital.

Limited partnerships provide several desirable charac­teristics for feedlot management. The major advantage

is that feedlot owners can acquire equity capital and maintain control of such capital as specified in the respective prospectuses. Cattle feeding funds, once estab­lished, generally assure feedlot owners that a certain pro­portion of their feeding facilities will be used during the life of the partnership. Custom feeding clients, in con­trast, can more easily exercise their option to enter or exit from a feeding enterprise at the end of each feeding period (lot closeout).

To the extent that feedlots arc able to raise equity capital through cattle feeding funds, this tends to decrease feedlot management concern with the lot utili-

3

zation problems. However, as exemplified in the past, cattle funds can provide this stability feature to the feeding industry in the longer run only if investors can realize returns from cattle feeding funds comparable to other forms of investment.

Profit incentives are not the sole investment criteria as indicated above. Much of the future demand for cattle feeding fund investments will depend upon the extent to which tax benefits exist in connection with them.

One of the major changes created by the 1976 tax legislation is that farming syndications or limited partner­ships will no longer be allowed to receive a tax deduction for prepaid feed and other expenses.' Custom feeding clients who feed their own cattle may continue to operate under the old income tax rules whereby prepaid feed expenses may be deducted from current income. Thus, a high-income investor might logically invest in cattle feeding as an individual custom feeding client rather than as a limited partner in order to deduct pre­paid feed expenses and maintain the value of his invest-

ment as a tax benefit, as well as an income-generating one.•

Some investors believe that the provisions limiting deductions to the amount of capital "at risk" also will have a significant adverse effect on investments because many cattle feeding fund investments are highly lever­aged. However, the critical determinant is the definition of capital "at risk." It includes cash and the adjusted basis of other property contributed to an investment, as well as any bo"owed funds for which the individual has persona/liability, and the net fair market value of personal assets which secure nonrecourse financing (8). It would appear that the "at-risk" limitation need not deter the astute investor who is aware of the legal limitations when borrowing money and investing in cattle feeding, but this limitation likely will have its greatest impact on investments generating substantial paper losses (e.g., depreciation). Thus, it may have a greater impact on other investments than on cattle feeding funds.

CONCLUSIONS

The 1976 tax legislation is not likely to have a major impact on the operation of large-scale commer­cial cattle feedlots, primarily because nonsyndicated custom cattle feeders may still receive a tax deduction for prepaid expenses. In addition, it is important to remember that limited partnership investments have never constituted the major proportion of the total investment in cattle feeding, even in the Southern Plains (1, 2). Rather these large feedlots are heavily dependent upon the investments of custom feeding clients who are not associated with syndicates, and, therefore, are unaffected by the 1976 tax legislation limiting deductions for prepaid expenses.

Much has been said and written concerning the high and continuously increasing capital requirements in agriculture. Indeed, there is concern over how the

future capital requirements in agriculture will be met. However, capital limitations existing in connection with a profitable enterprise lead to changing methods of financing. Furthermore, the large number of investors with large quantities of capital who obviously seek good investment opportunities support a hypothesis that the means of acquiring capital is more of a limiting factor than the availability of capital. This has implica­tions for financial institutions that currently service commercial agricultural firms. Many of these institu­tions are knowledgeable about agricultural production opportunities and are in a position to assess the invest­ment opportunities and communicate the investment needs of agriculture. These institutions must continue to evaluate their services and develop new and innova­tive financial policies and services when needed.

LITERATURE CITED

(I) Dietrich, R. A. Costs and Economics of Size in Texas-Oklahoma Cattle Feedlot Operations. Tex. Agr. Exp. Sta. Bul. I 083, Texas A&M Univ., College Station, Tex., May I 969.

(2) Dietrich, R. A., J. R. Martin, and P. W. Ljungdahl The Capital Structure and Financial Manage­ment Practices of the Texas Cattle Feeding

'These rules affect publicly registered syndications (e.g., cattle feeding funds), as well as private (unregistered) syndica­tions in which more than 35 percent of the losses for any period go to limited partners or limited entrepreneurs. See (8).

4

Industry. Tex. Agr. Exp. Sta. Bul. 1128, Texas A&M Univ., College Station, Tex., Dec. 1972.

(3) Youde, James G., and Hoy F. Carman Tax Induced Cattle Feeding California Agricul­ture, June 1972.

( 4) Matthews, Stephen F., and V. James Rhodes The Use of Public Limited Partnership Financ­ing in Agriculture for Income Tax Shelter. N.C.

• Of course, those investors who are not "bona fide" farmers could be subject to IRS "material distortion of income" arguments in an effort to rid these deductions.

Proj. 117, Mono. 1, Univ. of Missouri, Colum­bia, Mo., July 1975.

(5) Dietrich, R. A., D. R. Levi, and J. R. Martin Limited Partnerships in Texas Feedlots­Investor Characteristics, Investment Incentives and Fund Arrangements. Tex. Agr. Exp. Sta. Bul. 1175, Texas A&M Univ., College Station, Tex., Jan. 1977.

(6) Ludlow, Gregory T. The Influence of Limited Partnerships in Com­mercial Cattle Feeding. Master of Agriculture

Professional Paper, Texas A&M Univ., College Station, Tex., 1974.

(7) Empey, Lawrence G. The Limited Partnership: A Resident Invest­ment Device, Tax Ideas, Prentice-Hall, Inc., Englewood Cliffs, N.J., 1972.

(8) Sisson, Charles A. Provisions of Importance to Agriculture in the Tax Reform Act of 1976. ERS-645, Econ. Res. Ser., U.S. Dept. Agr., Nov. 1976.

5

Issues Related to Entry of Young People into Farming

J. Bruce Hottel and Peter J. Berry I

Entry problems of young people into farming warrant and continue to receive attention from farmers, policymakers, and others concerned with a viable farm sector. In 1974, for example, a conference on their financial needs, sponsored by the Farm Credit System, provided additional insight in determining how to meet young farmers' credit needs more effectively (I 1). A more recent survey of agricultural bankers showed that the financing of young farmers ranked as their first concern (1).

The Farmers Home Administration (FmHA), an agency of the U.S. Department of Agriculture, has for nearly four decades been involved with a supervised credit program for beginning farmers and farmers who lacked funding from commercial sources (20). Although it failed to be adopted, national legislation was proposed in a recent session of Congress for a "Young Farmers

Homestead Act" which attempted to establish govern­ment assistance through real estate lease-purchase pro­grams for young people (22). Similar legislation had been prepared for 1977. Some States, such as Minnesota, have initiated credit programs that would aid young farmers, as well as others, in obtaining credit for acquir­ing real estate (16). In a recent article, Boehlje indicates several research implications arising from entry (and other) problems in agriculture (6).

This paper addresses two basi9 questions related to the entry problem. The first concerns the severity of the problem. The second concerns the need to evaluate economic consequences of alternative social objectives on the optimum numbers of farmers and of public poli­cies that will enhance the entry and establishment of new farmers.

ENTRY PROBLEMS IN AGRICULTURE

Ba"iers to entry: Numerous issues and vantage points are involved in considering whether difficulties in gaining entry into farming are relatively more serious than gaining comparable access to other sectors of the U.S. economy. As an example, one might reasonably ask whether the "barriers" to entering production of oil, automobiles, shoes, televisions, or even banking, are more serious than those of entering agriculture.

If "entry" is defined to include the investment of capital and the ownership of resources, then the answer is likely "yes." However, these nonagricultural industries are generally organized to employ skilled human resources without large or direct investments of capital by those employed. The fanning sector is not so organ­ized and, with the exception of renting real estate, has

1 Agricultural economist, Economics, Statistics, and Coopera­tives Service U.S. Department of Agriculture, stationed at Texas A&M University, and Associate Professor, Department of Agri­cultural Economics, Texas A&M University, College Station.

6

exhibited relatively little separation of ownership and control of resources. However, the structural organiza­tion of the farming sector could change significantly, just as it has evolved in most nonfarm industries.

Several factors have combined to increase the diffi­culties of gaining access to agricultural production. One factor is the increasing costs of resources, especially land and machinery, over the past several years. Closely re­lated is the increasing size of operations as measured by acreages, cows milked, pigs fed, etc. Both factors have combined to significantly increase capital investment requirements. Increased size of operation has resulted from the need to adopt and use new technology more efficiently, to gain size economies, to gain higher incomes, and, in some cases, to exercise superior man­agement ability.

Data in table 1 provides examples of the capital requirements for farm proprietorships with annual gross farm sales of $40,000- $60,000. These estimates indi­cate that to be an owner-operator a young farmer must

Table 1-Capital requirements for single farm proprietorship with $40,000-$60,000 gross farm sales, 19761

1976

Type of farm Farmland Other Total value capital capital

Dollars

Cash grain ................ 293,643 85,036 378,679 Cotton •••••••• 0 ••••••••• 299,421 113,086 412,507 Livestock ranch ........... 458,806 113,750 572,556 Vegetable ................ 174,022 72,290 246,312 Fruit and nut ............. 195,762 89,666 285,428

'Compiled from the 1970 Farm Finance Survey [21], but updated to 1976 to reflect changes in the value of farm assets.

face very high capital requirements to begin a farming operation of reasonable size. However, the ability to acquire equity capital and to lease or rent real estate and other resources is an important factor among younger farmers and likely helps to explain how many young people enter farming.

Many young farmers also enter the industry by successfully combining farm and nonfarm employment. Nevertheless, younger people may still experience diffi­culties in providing the necessary equity base with which to start farming. Even if a young vegetable farmer were to achieve a leverage ratio (debt to equity) of 10 to 1 in the above example, for vegetable farming, he would still need $24,631 of equity capital. Cruitt, Obrecht, and Herr estimate that when one considers the ratio of bor­rowed, rented, and jointly operated resources to equity for young midwest grain farmers, this ratio may be on the order of $18-20 to $1 ( 7).

Estimates from the 1970 Survey of Agricultural Finance indicate an average ratio of resources controlled on indebted farms (owned and rented) to equity for all U.S. operators under age 35 of $5 to $1 (.20) (table 2).

Based on this ratio, the indebted U.S. farmer under 35 has a relatively high current average equity of $44,238.

Additional insight on agricultural entry problems may be gleaned from a review of the relevant financial characteristics of established operations. These charac­teristics are germane because the means of entry used by new farmers often determines the financial and business organization of their farms for many years to follow. Information concerning the initial and current financing of 104 young farmers attending the Young Farmer Credit System Conference in 1974 indicates heavy reliance on parents, friends, and relatives for their start­ing sources of credit as (11): 2

Average Sources of Credit

Parents, friends, relatives Farmers Home Administration Major institutional lenders Merchants, dealers, etc.

1963 1974

Percent

44 11 40

5

20 3

72 5

Parents and relatives were also important sources of equity capital.

Average Sources of Net Worth in 1963

Percent

Inheritance and gift Own work and saving Wife's work and savings Other

41 43

6 10

2 Although data from young farmers attending this Confer­ence do not necessarily reflect the situation encountered by the total population of young farmers, other studies reflect similar patterns with respect to gaining entry and growth patterns (13, 19).

Table 2-Distribution of farm operators, average debt, and average value of land and buildings, United States, January 1, 1977'

Average value on farms with debt

Age group Farm opera- Value of land and buildings Ratio of operator equity to: Age distribution tors with debt

I Total debt Owned by L&B value Entire L&B

Entire farm operator owned values

Percent Dollars Percent

Under 35 ........ 11.6 66.6 52,005 221 '190 96,406 46 20 35-44 .......... 19.7 66.9 59,276 243,373 135,022 56 24 45.54 .......... 27.9 58.1 54,331 262,195 160,441 66 40 55.64 .......... 26.2 41.0 43,757 233,125 163,701 73 51 65 and over ...... 14.6 26.2 31,866 198,4 76 153,428 79 61

All groups ...... 100.0 . . . ... . . . . . . . .. . ..

1 Estimates for Jan. 1, 1977 are based on projection of average debt and building values from the 1970 Farm Finance Survey to reflect changes in the value of debt and land from 1970 to 1977 [21].

7

The changes in these farmers' farm units from 1963-74 and their expectations for 1980 are reflected in table 3.

Table 3-Progress and goals of farmers attending Young Farmer Credit System Conference in 1974

Progress and goals

Acres owned ........ . Acres rented ........ . Acres farmed jointly .. .

Total acres ........ .

Debts ............. . Net worth (equity) ... . Assets owned (market

value) ........... . Assets controlled

(market value) ..... .

Equity to assets owned ........... .

Equity to assets controlled ........ .

Debt to equity ...... .

Source: ( 11)

1963

60 90 90

240

16,000 14,000

30,000

75,000

.47

.15 1.14

Number

270 400 160 830

Dollars

1980

575 695 N/A

1,270

132,000 220,000 190,000 370,000

322,000 590,000

635,000 1,034,000

Ratio

.59

. 30

.69

.63

.36

.59

While this information reflects the experiences of the more successful young farmer, it still indicates that farm­ers generally need loans that are large relative to their incomes and assets. Sometimes these loans are larger than most institutional lenders are willing to give, and their debt loads are higher in relation to their equity. This means that further study is needed on those who experienced less success or who failed to establish or maintain their operations.

In a recent article, concerned with growth and finan­cial strategies of farmers, Barry and Baker point out that data from the 1969 Census, together with other research findings, indicate that a farmer's life cycle strongly in­fluences his pattern of debt use and resource control (4). Full ownership rises and tenancy declines with age, while part ownership rises through the 45-54 age bracket and then declines. The proportions of part owners are larger in those age brackets (35-54) years where farm size is largest, suggesting the important role of leasing in financing firm growth. During the growth stage, a blend of leasing and ownership provides financial diversifica­tion, stabilizes resources control, and builds credit. Then, as farmers approach retirement and estate transfer, they tend to relinquish control of leased acreage and maintain their operation on owned land. As they retire, their operation becomes the source of newly leased land.

Barry and Baker also note that although the family operation generally serves as a norm upon which much analysis can be centered, there are numerous spinoffs from the family operation and a growing number of

alternative organizations which warrant attention as well (4).

The farm may fully occupy the family's resources or it may offer only part-time employment with considera­ble time spent off the farm in nonfarm employment. The operator may specialize in crop and livestock pro­duction or reflect some combination, each with signifi­cantly different requirements for capital, finance, mana­gerial skill, etc. Farmers and ranchers often pool resources for more efficient operation. Other operations emerge as joint ventures, labor sharing arrangements, partnerships, or mergers. Some firms emphasize leasing of fixed capital, especially real estate, and use loans to finance working capital. Other farms have emphasized investment in value-appreciating assets, especially land. Such operations can and do grow extremely large, a]. though still operated as proprietary firms.

Related closely to these factors, and having mixed effects on access to farming, is the family farm orienta­tion. To a large extent, family orientation is inherently self-generating. The strength and staying power of family proprietorships in the farming sector are great and can be attributed at least, in part, to farming's innovation and enterprise and the perseverance of farm and ranch families during periods of economic adversity .

The family unit operating a farm or ranch has a pro· pensity to produce and develop their own replacements and thereby preserve the future survival of the family farm. But how many farm youths are needed as replace­ments and which ones are granted entry? Even with family assistance, the opportunities for entering farming are rather limited and increasingly competitive.

Lu, Horne, and Tweeten estimate that during 1965-74, low availability of single farm units available for occu­pancy meant that only two of five Oklahoma farm youth had the opportunity to enter farming (14). More­over, the family with superior financial resources can favor their youth over the less financially advantaged farm or nonfarm youth who may have even greater promises of success. This question, of course, could be asked about any occupation.

Another factor limiting entry into farming is the wide diversity of managerial skills needed to operate today's farms. In a study of Minnesota farmers, Thomas and Jensen indicate a substantially better chance of suc­cess for excellent managers as compared to those of "average" ability (19). Skills in effective financial man­agement have had a high payoff and, quite recently, marketing skills, to cope with price risks, have become more relevant than in the past.

Acquiring these skills requires heavy ~ommitments of time and capital in educational activities and prac­tical experience. However, the payoffs appear promis­ing, both in terms of gaining entry and assuring later success.

Recent information on age distribution of farmers indicates an increase in the relative number of farmers under age 35. From 1970 to 1976, the number of young

persons (ages 16-34) self-employed in agriculture actual­ly increased about one-third, rising by about 94,000 (5).

While entry is more competitive, it appears that those who are willing and capable of gaining access to farming have generally been able to do so with sustained success.

Indeed, their problems are less associated with gaining entrance than they are with evaluating new technology, managing market and yield risk, and staying in opera­tion. Nonetheless, most young farmers tend to have farm backgrounds and, thereby, are likely to have significant family assistance.

POLICY ISSUES AND FARM NUMBERS

Evaluation of Policy Alternatives: Any analysis of young farmers' problems depends heavily on the eco­nomic criteria by which the structure of the U.S. food and fiber system is evaluated. These criteria become the economic base for evaluating agriculture's performance, organizational structure, and related public policies.

Suppose we evaluate the question of a desirable num­ber of farmers in terms of two vantage points on social objectives held toward agriculture. Consider first the vantage point of domestic and foreign consumers of food and fiber, and, second, the vantage point of U.S. farmers and ranchers.

For consumers, a reasonable objective of the food system might be the delivery of food and fiber at low, stable costs with reasonable profits to those participat­ing in production, distribution, processing, merchandis­ing, and so on. This consumer view would let the farm sector adjust to an organizational structure that best meets these social objectives and, while evidence is not conclusive, past situations indicate movement towards larger farming operations that are managed and capital­ized by those best able to provide the necessary resources. While these operations may continue to exhibit a family orientation, present day situations sug­gest less opportunities for gaining entrance to agriculture as an owner-operator and more emphasis on control of resources through leasing arrangements and vertical coordination in markets for products and resources. Also more emphasis will likely be given to outside equity capital entering agriculture, limited partnerships, com­mon stock, and agency services. These methods, com­monly used in financing the growth of large livestock feeding, breeding, citrus, and vineyard operations, have their appeal based on profit potential and, at least in the past, on tax savings associated with the unique features of agriculture.'

In addition, the increased concentration of produc­tion on fewer farms of larger size and the increased market coordination of processing, distributing, and retailing firms may increasingly shift the control of production decisions off the farms. If these changes continue, they could provide further barriers to the entry of new family farmers, although large-scale

'Although the Tax Reform Act of 1976 may have changed the investment incentive for certain types of investors, the tax aspects are still important for nonfarmers and farmers alike (8, 17, 18).

agriculture with greater market coordination may actually enhance the entry of well-trained, highly-skilled young people as managers, technicians, and other spe­cialized functions.

On the other hand, if the vantage point shifts from consumer to farmer which would be reflected by a preference for greater numbers of farmers operating and smaller sized units on the average, then agriculture may well experience lags in adoption of new technology, difficulties in market coordination, and potential losses in economic efficiency. Thus, these implications should suggest a continued government assistance to help less capitalized and, perhaps, less competent persons gain control of the necessary resources to insure survival.

A somewhat similar view is expressed by Heady and Sonka (1 0). They indicate that important trade-offs face the American public as policies are promoted which favor a particular size farm structure or as market forces and new technology continue to cause increases in farm size.

There are no simple answers to these issues. As an example, the economies of size question is not conclu­sively resolved and additional research is needed to determine efficient sizes and organizational structures of farm businesses. Some studies have indicated that small farms can gain significant economies through expanding to intermediate sizes, although constant size economies appear to hold in further expansion (15).

A recent USDA report provides evidence supporting the hypothesis that rates of return on large farms exceed those earned on small farms. Farms with gross farm sales of over $100,000 in 1970 were earning an average of 6.9 percent on equity capital, while farms with gross fann sales of less than $2,500 were losing an average 6.1 per­cent on equity (1 2).

Operators ofsmall farms, however, continue to survive despite low rates of return on equity from the farm operation. According to the U.S. Bureau of Census data, farmers with gross farm sales below $5,000 in 1970 obtained over 90 percent of their total income off the farm. Thus, it appears that small farms rely greatly on off-farm income.

While there has been little study of the operating effi­ciencies achieved by very large, nonfamily operations, large operations clearly realize some obvious inefficien­cies, e.g., the higher costs of hired management and labor. Even though evidence is limited, it appears that larger operations may, too, experience meaningful

l)

savings in buying their resources and in selling their products.

The key point is that policy alternatives should be carefully evaluated in terms of their economic impact. Hence, there is a need for effective research to evaluate their impacts on markets, resource allocation, and dis­tribution of wealth.

Policy Issues: If our policy is one of some mix be­tween the two mentioned alternatives, the degree of government subsidization or market involvement in policies designed to enhance the prospects of entry and success in farming should be carefully evaluated.

A 1976 proposal that exhibited characteristics of having substantial impact on market forces was the "Young Farmers Homestead Act" (22). It proposed the Government's purchase, lease, and ( concessional) sale of farmland to young farmers otherwise unable to buy farmland. The plan was well intended and had many fine features. And, although it was designed to avoid tamper­ing with land markets and valuation, it would have likely generated some increase in the demand for land and put upward pressure on land prices. However, the lease obli­gation under this program appeared to exert a potential­ly large drain on the young farmer's cash flow-but so would financial obligations associated with subsequent land purchase. Thus, limits on size of tract could have retarded the growth of a participant, perhaps assuring, permanently, his position as a small family farmer.

Barry and Baker question whether policies for young farmers that foster still more debt capital in agriculture are needed (4). Instead, the need may lie in reducing the financial disadvantage of the smaller, yet productive operator, whether he is young or not so young. Capital gains, tax advantages, equity based land expansion, out­side income, and related features already help the more financially aggressive to gain competitive advantages over those with equal or even superior skills in production and marketing.

Other policy alternatives warranting consideration for aiding young farmers would be a policy that would be less disruptive of land and capital markets and which could involve tax incentives for those who sell or lease real estate to qualified young farmers at concessional prices (4). Such an arrangement would lower cost-of-purchase or rental rates for young farmers, while maintaining the sellers' or lessors' returns. Also, since a high proportion of farmers start by leasing resources and purchasing land through seller mortgages and contracts, emphasis could be placed on public sponsored insurance programs to cover the farmers' risks in meeting these obligations. The reduced risks of loss would make both lender and seller

10

more willing to provide the financing for the sale. Where land is sold by retiring farmers, special tax

consideration might be given to "inverse" amortization schedules with lower payments at the beginning of the loan period and higher payments later on. This repay­ment pattern would ease the cash flow problem for young farmers but still compensate retiring farmers for the higher risk and lower cash return in early years of the financing period. Another alternative would be a land tax levied on farmers who use unrealized capital gains on their currently owned land as equity in financ­ing the acquisition of additional land. While this propo­sal may lessen the demand for land from certain groups, it could improve the chances for access of land by the smaller operator. However, it would certainly not pro­vide guaranteed success in acquiring or operating land.

In addition, increased emphasis could be given to the expansion of Government guaranteed Joan programs through private lenders that allocate part of their loan portfolios to young farmers. The FmHA could adminis­ter programs which would complement their current programs. The FmHA currently offers various kinds of direct and guaranteed loan programs for commercial lenders and disadvantaged farmers. However, these pro­grams play more of a defensive role in responding to risk and are not generally considered in the mainstream of financial planning for (young) farmers needing such assistance.

As of January 1, 1976, the FmHA held an estimated 6 percent of the total real estate and nonreal estate debt outstanding. While 6 percent of the total debt is not large, the relative importance of these loans can be appreciated better when their outstanding debt is examined by economic class and age group of their borrowers (table 4). Thus, borrowers under 35, with total value of farm sales under $10,000 in 1971, relied upon the FmHA for 22 percent of their real estate loan funds. In contrast, borrowers over 65, with gross farm sales over $40,000, relied on the FmHA for Jess than 1 percent of their real estate loan funds. Thus, the relative importance of the FmHA as a supplier of debt increases as the age and value of farm sales of the borrower decrease.

Developments of private financial institutions could also help. Designing loan programs that would directly confront the farmer's income variability through variable amortization, debt reserve, Joan insurance, etc., would help (2, 3) ease the financing of resource control for new, qualifying farmers and make their access to financ­ing more stable and predictable. As a result, these farmers could better bear risks in marketing and production.

Table 4-Distribution of real estate debt outstanding by lender source, classified by age, and sales class of borrower 1

Age of borrowers Total value of farm sales

J j l j65 and over Under 35 35 to 44 45 to 54 54 to 64

Over $40,000 Federal Land Banks ....................... 24.5 26.5 29.3 32.2 31.3 Farmers Home Administration ............... 5.2 5.2 3.0 3.4 .2 Life Insurance Companies ••••••••••••••••• 0 22.3 16.0 22.0 23.8 25.6 Commercial Banks ••••••••••••••••••• 0 •••• 14.9 13.7 17.2 19.6 23.8 Individual and Others ...................... 33.1 38.6 28.4 20.9 19.0

$10,000. $39,999 Federal Land Banks ....................... 17.9 20.0 29.2 40.5 33.9 Farmers Home Administration ............... 17.5 17.7 15.4 7.4 4.5 Life Insurance Companies .................. 4.6 8.7 12.6 19.2 18.5 Commercial Banks ••••••• 0 •••••••••••••••• 16.5 14.3 12.8 13.1 15.8 Individual and Others ...................... 43.5 39.4 30.1 19.8 27.3

Under $10,000 Federal Land Banks •••••• 0 •••••••••••••••• 12.1 22.0 23.4 32.8 34.0 Farmers Home Administration ............... 22.3 14.3 19.5 13.0 13.7 Life I nsu ranee Companies .................. 4.7 5.5 10.0 12.2 14.7 Commercial Banks ........................ 24.5 18.0 18.7 15.8 11.7 Individual and Others ...................... 36.5 40.2 28.4 26.3 25.8

1 Abbreviations used are: Federal Land Banks (FLB), Farmers Home Administration (FmHA), Life Insurance Companies (LICO), Commercial Banks (CMBK) and Individual and Others (1&0).

Source: The 1970 Agricultural Finance Survey data were used to construct this table. [21] .

CONCLUSIONS

Drawing conclusions on the entry problems of young farmers is somewhat difficult. Principal difficulties appear to be a lack of hard evidence which documents the severity of the problem and the appropriateness of the various vantage points for viewing the problem. Some observers would argue that entry problems are not as severe as their notoriety warrants, especially in com­parison with entry problems experienced in other indus­tries. Also, this view suggests that the United States does not appear to be experiencing a shortage of farmers,

especially if certain economic criteria are used in assess­ing the desirable numbers of farmers. In contrast, a view­point strongly emphasizing the family farm orientation would likely reach conclusions that are just the opposite. Clearly, there is need for stronger information and research bases that specifically address the problems of the young farmer. This information would assure that future public policies to enhance the entry and estab­lishment of new farmers by means of heavy government subsidy or market involvement are desirable features.

LITERATURE CITED

(I) American Bankers' Association Agricultural Banker Special Report. Apr. 1977.

(2) Baker, C. B. "A Variable Amortization Plan to Manage Farm Mortgage Risks." Agr. Fin. Rev. Vol. 36, Apr. 1976.

(3) Barry, P. J. and D. R. Fraser "Risk Management in Primary Agricultural Pro­duction: Methods, Distribution, Rewards, and Structural Implications," American Journal of Agr. Econ., Vol. 58, No. 2, May 1976, pp. 286-295.

(4) Barry, Peter J. and C. B. Baker "Management of Firm level Financial Struc­ture," Agricultural Finance Review, Vol. 37, U.S. Dept. Agr., Econ. Res. Serv., Feb. 1977, pp. 50-63.

(5) Beale, C. L. From unpublished data prepared by Population Studies Group. U.S. Dept. Agr. Econ. Res. Serv., from Statistics of U.S. Dept. of Labor, Employ­ment and Earnings, BLS.

(6) Boehlje, Michael "The Entry-Growth-Exit Processes in Agricul-

11

ture," Southern Journal of Agr. Econ. Vol. 5, {14) Lu, Yao-Chi, James Horne and Luther Tweeten No.1, July 1973. Farming Opportunities for Farm Youth in

(7) Cruitt, S., K. Obrecht and W. Herr Oklahoma and the U.S. Okla. Agr. Exp. Sta. "Financing Entry into Midwest Farming." Bul. B-683, Sept., 1970. Dept. of Agr. Ind., Carbondale, Ill., June (15) Madden, J. Patrick 1976. Economies of Size in Farming. Agr. Econ. Rpt.

(8) Dietrich, R. A., D. R. Levi, and J. R. Martin 107, U.S. Dept. Agr., Econ. Res. Serv., Feb. Limited Partnerships in Texas Feedlots, 1967. Investor Characteristics Investment Incentives {16) Minnesota State Dept. of Agriculture Fund Arrangements. Tex. Agr. Exp. Sta. and Family Farm Security Act of 1976, Minne-U.S. Dept. Agr., B-1175, Jan. 1977. apolis, Mn.

(9) Epperson, James E. and Sidney C. Bell (17) Sisson, Charles A. Getting Established in Farming with Special The Tax Reform Act of 1976: Provisions Reference to Credit. Agr. Exp. Sta. Bul. 400, Which Will Affect the Farm Sector. Agr. Econ. Auburn Univ., Auburn, Ala., Apr. 1970. Rpt. No. 64 7, U.S. Dept. Agr., Econ. Res. Serv.

{10) Heady, Earl 0. and Steven T. Sonka Nov. 1976. "Farm Size, Rural Community Income, and {18) Sisson, Charles A. and Fred Wood Consumer Welfare." American Journal of Agr. "Tax Aspects on Agriculture," Tax Notes Vol. Econ. Aug. 1974, pp 534-542. 5, July 1977.

(11) Herr. William {19) Thomas, Kenneth H. and Harold R. Jensen "A Statistical Close-Up of Conferees," Finane- Starting Farming in South Central Minnesota, ing Young Farmers, Report of the Conference Guidelines, Financial Rewards Requirements. on Financial Needs of Young Farmers. FCA, Sta. Bul. 499, Agr. Exp. Sta., Univ. of Minne-Feb. 25-27, 1974. sota, 1969.

(12) Hottel, J. Bruce and Robert D. Reinsel (20) U.S. Dept. Agr. Returns to Equity Capital by Economic Class Brief History of the Farmers Home Administra-of Farm. Agr. Econ. Rpt. No. 347, U.S. Dept. tion. U.S. G.P.O., 667785/48, Jan. 1975. Agr., Econ. Res. Serv., Aug. 1976. (21) U.S. Dept. Com.

{13) Kaldor, Donald R. and Thomas C. Jetton Farm Finance. Bureau of the Census, Part II, Characteristics of Operator Entry into Farming, Vol. V., Spec. Rpt. Aug. 1974. 19 59-60. Research Bulletin 546, Agr. & Home (22) U.S. Congress Econ. Exp. Sta., Ames, Iowa, Iowa State Univ. HR-18495 S-2589 (94th Congress and 95 Con-Aug. 1966. gress). 1975-1976.

12

Impact of Welfare Reform on Rural Areas

Thomas A. Carlin and Lindo M. Ghelfl'

The current welfare system is both a major party issue and an object of criticism. It has been argued that the system is costly; and, with several government agen­cies administering different programs to the same target group, administratively inefficient (2). 2 The present set of programs does not treat all families in similar circum­stances equally; for example, in some States, cash pay­ments are provided to female-headed families with children, while similar male-headed families are ineligible for benefits (2). Also the work incentives vary. In some States, when families participate in several welfare programs, they may lose almost a dollar in benefits for each dollar earned, thus discouraging work (2). Further­more, the benefit levels vary considerably among the States.

Many proposals have been made to improve the wei-

fare system. Some suggest modifying the present pro­grams to make them easier to administer and more equitable. Others recommend replacing the system with a single broad-based income maintenance program (6). The latest such proposal is the Program for Better Jobs and Income (PBJI), the Carter Administration's welfare reform plan, which was presented to Congress on August 6, I 977 (17). This paper will deal with both the impact in rural areas of a broad-based income main­tenance system, such as the PBJI and with provisions which would differentially affect rural residents. Rural areas have a basic stake in the outcome of welfare reform debates. Depending on the alternatives chosen, a broad-based income maintenance program would sub­stantially increase the incomes of rural families, especially in the South.

BASIC PROVISIONS OF THE PROGRAM FOR BETTER

JOBS AND INCOME

The Program for Better Jobs and Income (PBJI) would replace the current Aid to Families with Depen­dent Children (AFDC), Supplemental Security Income (SSI), and Food Stamp programs and expand the role of the Comprehensive Employment and Training Act (CETA) public-service employment programs (7). 3 Pro­posed to begin in the fall of I 980, PBJ I would encourage all low-income family heads and single persons who are able to work to do so, and provide an income floor for all families and single persons who are not normally expected to work. The proposal consists of two basic tracks: cash assistance only and jobs plus some cash assistance.

1 Economist and Social Science Analyst, respectively, Economic Development Division, Economics, Statistics, and Cooperatives Service, United States Department of Agriculture.

2 Italicized numbers in parenthesis refer to literature cited at end of ths report.

3 An overview of the current welfare system is presented in the Appendix.

Cash Assistance Only Track

A basic payment of approximately two-thirds of the official poverty threshold would be provided primarily to those not expected to work. Those eligible include:

-the aged, blind, or disabled; -single-parent families with children under age 7 (or

between 7-13 when a job and day care are not available);

-two-parent families with young children where one parent is incapacitated; and

-persons who cannot find work (these persons would revert to the other track once a job becomes available).

A family of four with no other income would receive $4,200 (table I). These are uniform national payment standards, with States free to supplement the basic payment.

Heads of single-parent families with a child aged 7-13 are required to work part-time and may work full-time if adequate day care is available. For others in this track,

13

Table 1-National basic payments under the Program for Better Jobs and Income, by family type, proposed on August 6, 1977 1

Basic payments for those:

Expected to work Family type Not expected to work

Benefits during 8-week I or for which no job is avai I able job search Benefits if job refused

Two-parent family Dollars

Adult head .............................. . 1,900 -0- -0-Other adult .............................. . 1,100 $1,100 $1 '1 00 Each child regardless of age with maximum of

7 persons per family ..................... . 600 600 600

Single-parent family (with youngest child aged 14 or over)

Head of household ...................... . 1,900 -0- -0-First child ............................. . 1,100 1,100 1,100 Each additional child with maximum of 7

persons per family ..................... . 600 600 600

Single-parent family (with youngest child under 14) 2

Head of household ...................... . 1,900 1,900 -0-First child ............................. . 1,100 1 '100 1,100 Each additional child with maximum of 7

persons per family ..................... . 600 600 600

Aged, blind, and disabled 3

Couple ................................. . 3,750 Single individual .......................... . 2,500

Childless couples Each adult .............................. . 1,100 1,100 -0-

Single individuals ........................... . 1,100 1,100 -0-

1 The basic payment is the payment to a recipient when no other income is available. No State supplementation is assumed. 2 Heads of single-parent families with youngest child under 7 are not expected to work. 3 The aged, blind, and disabled are not expected to work.

Source: U.S. Department of Health, Education, and Welfare, HEW News, Aug. 6, 1977.

work is not required. Recipients earning income would have their benefits reduced by 50 percent of earned income in States which do not supplement or by no more than 70 percent of earned income in States which do supplement.4

Jobs Plus Cash Assistance Track

A basic payment of approximately 36 percent of the official poverty threshold would be provided to two­parent families, couples, single-parent families with the youngest child aged 14 or older, and single individuals, all of whom are required to work (see table 1 ). A family of four would receive a basic benefit of $2,300. Benefits would be reduced by 50 percent of earned income after disregarding the first $3,800, 80 percent of nonemploy-

4 For single-parent families with a child aged 7-13, the first $3,800 of earnings can be disregarded before applying the bene­fit reduction rate.

14

ment income, and 100 percent of other means-tested assistance. A four-person family, with earned income only, ceases to be eligible for benefits when income reaches $8,400 ($3,800 + [$2,3,00 ..;- 0.5] ).

Principal wage earners in families with children, who could not obtain a private-sector job, would be eligible for public-sector jobs (about 1.4 million jobs would be provided the first year). State and local governments would be encouraged to create public-service jobs which would be financed primarily by the Federal Govern­ment. Persons in public-sector jobs would receive the Federal minimum wage except in those areas where the State minimum wage is higher. After 1 year in a sub­sidized public-service job, the job participant must spend 8 weeks looking for an unsubsidized job before again becoming eligible for a subsidized job. 5 There would be

5 There are additional provisions which cover situations as family moves through the job track.

no income or assets tests for determining eligibility for public-service employment.

The Earned Income Tax Credit (EITC) would be modified to make jobs in the private-sector preferable to public-service employment. 6 A 10-percent refundable personal tax credit on earnings up to $4,000 and a 5-percent refundable credit on earnings between $4,000 and a maximum determined according to family size would be available to all families on earnings only from unsubsidized jobs (7). 7 The EITC would be reduced by I 0 percent of unsubsidized earnings above the maximum.

To reduce the welfare fiscal burden for all States, the proposal guarantees the States a minimum 1 0-percent savings over current welfare expenditures. These savings would be accomplished through a hold harmless provi­sion in which the Federal Government agrees to pay the difference between 90 percent of a State's current welfare costs and the State's cost of the PBJ I. The Administration's proposal also requires States to pass along fiscal relief to local governments in proportion to the share of State welfare costs currently borne by these localities.

Impact of PBJI on Rural Areas

A detailed analysis of the impact of PBJI on rural areas was not available at the time this paper was pre­pared (August 1977). However, rural areas, particu­larly in the South, are expected to benefit from the Ad­ministration's proposal for two basic reasons. First, the national benefit levels included in the proposal ($4,200 for a family of four) are substantially higher than the combined Federal-State benefits currently provided (to a family of four) in 12 States: Alabama, Arizona, Arkansas, Florida, Georgia, Louisiana, Mississippi, Missouri, North Carolina, South Carolina, Tennessee, and Texas (I 7). 8 With the exception of Arizona and Missouri, all these States are located in the South. Second, the proposal would provide public assistance benefits to male-headed families, families with no chil­dren under 18, and single individuals, all of whom are generally excluded from the current AFDC program

6 For a detailed discussion of the earned income tax credit and impact on rural areas, sec (5).

'Maximum income covered by the 5% credit is as follows:

If the number of deductions for personal exemptions is:

2 ...... . 3 4 5 6 7ormore ............ .

The amount is: $6,500

7,800 9,100

10,400 11,700 13,000

'For example, an unemployed female-headed family of rour in Mississippi could receive $720 annually in AFDC pay­ments in 1976 and he eligible for $1,836 in bonus Food Stamps for total benefits of $2,556. This total is $1,644 less than the $4,200 payment und,•r PBJ I.

(with the exception of AFDC-Unemployed Father benefits offered in 27 States) (7). There is a higher incidence of poor male-headed families in nonmetro areas (relative to all poor families), and these nonmetro families, too, are disproportionately located in the (table 2). Similarly, there is a higher incidence of poverty among nonmetro unrelated individuals, particu­larly in the South. Thus, the combined effect of national benefit standards, which are higher than current welfare payments in some States, and new eligibles, who are disproportionately located in nonmetro areas would result in larger income flows to many rural communities.

Detailed analysis of earlier broad-based welfare reform proposals support this general conclusion. For example, a welfare reform program proposed by the Joint Economic Committee, U.S. Congress, in 1974, would have altered the distribution of welfare benefits away from urban areas in the North and West to southern urbanites and away from urban areas generally to rural residents, particularly in the South (6, p. 13). like the PBJI, the Joint Economic Committee's pro­posal would have established national benefit levels and eligibility standards, and the eligible population would have been similar to that of PBJI.

Similarly, the Family Assistance Plan (F AP), first proposed in August 1969, would have substantially increased the welfare benefits going to poor rural resi­dents in the Southern region (1 1). Only families with children would have been eligible to participate in F AP, although F AP contained national payment and eligibility standards. While specific provisions of PBJI are different from those of earlier proposals, PBJI is expected to have the same general impact on rural residents, particularly in the South.

Since 1970 and for the first time this century, popu­lation has grown faster in nonmetropolitan areas than in metropolitan America (3). Much of this population growth has resulted from net migration into smaller cities, towns, and open country. The phenomenon is pervasive, affecting every region and every State across the country. It is extremely conjectual whether national benefit standards would significantly impact this popula­tion trend. Past research shows that differentials in wel­fare benefits under current (AFDC') programs among States and regions had little influence on out-of-the­South migration during the sixties.9

An analysis of the 1970 Census of Population data, conducted by Long, suggests that Southern black migrants, including female-headed families, to the six largest predominantly Northern cities were less likely to be poor or on welfare in 1970 than Blacks born and reared in cities (12). Among Whites in the six cities, there was no consistent relationship between migration status and being poor or on welfare, except for slightly higher than average rates among the Southern born.

• Average AFDC payments in the South arc substantially lower than in Northern and Western States, as noted above.

15

Table 2-Families and unrelated individuals by poverty status, residence, and region, 1974

Total Percent nonmetro residing in: Family characteristics number Percent

I North Central I I (1,000) non metro Northeast South West

Families

All families ..................... 55,712 32 15 29 44 12 All poor families ................. 5,108 40 8 19 62 11

Poor families with: Male head less than 65 ........... 2,141 49 8 20 59 13 Male head 65 and older .......... 616 56 4 21 70 5 Female head less than 65 ......... 2,208 26 11 16 61 12

With youngest child less than 7 .. 1 '191 24 14 17 52 17 With youngest child 7 to 13 ..... 620 24 6 15 71 8 With youngest child 14 to 17 .... 152 34 11 15 67 7

Female head 65 and over ......... 144 42 7 23 67 3 Childless couples, head less than 65. 501 49 5 21 61 13 Childless couples, head 65 and over. 498 56 4 23 68 5

Unrelated individuals

All unrelated individuals ........... 18,885 27 16 31 39 14 All poor unrelated individuals: ...... 4,824 36 14 26 48 12

Less than 65 .................. 2,755 30 16 23 45 16 65 and over ................... 2,068 44 11 29 52 8

Source: Special tabulations from the Mar. 1975 Current Population Survey conducted by the U.S. Bureau of the Census.

Beale found no statistically differences in the receipt of welfare income assistance between rural-urban black migrant families or individuals and urban natives (4). These inferences were based on an analysis of the Survey of Economic Opportunity taken in 1967.

An Abt Associates, Inc., study, released in March 1970, on the causes of rural to urban migration among the poor, using interview data collected in 6 cities and 24 rural counties, concluded that perception of greater availability of public assistance in urban areas did not correlate in any consistent pattern with migration behavior (1). As the discrepancies in current welfare pay­ments among States did not significantly influence migration in the past, it seems unlikely that the Adminis­tration's proposal, which narrows these State differ­ences, would significantly influence migration decisions in the future.

Provisions of Particular Concern to the Self-Employed

The in tent of most welfare reform proposals is to restrict program participation to the truly needy. How­ever, identifying those families is difficult given the dynamic character of the poverty population. The results of a recent University of Michigan study of about 5,000 U.S. families, in which detailed income data were obtained over a 6-year period, showed that only abut 3 percent of the total U.S. population (by applying panel data to Census counts of poor each year) were in pov­erty each of the 6 years (1 6). About a quarter of the U.S. population was in poverty at least once during the 6-year period.

16

Asset tests and income accounting are the primary eligibility criteria used to limit welfare benefits to the desired population. Because the self-employed can experience fluctuating incomes more frequently than wage workers, the specific details of asset tests and income accounting can affect their inclusion in the pov­erty population and, thus, participation in welfare pro­grams (14).

The asset tests in most welfare programs are designed to assure that families with low incomes, but substantial assets, may not receive welfare benefits. In essence, families are encouraged to exhaust their economic resources before public assistance is provided. Some proposals place direct limits on the amount of assets a family may have to be eligible for welfare benefits. 10 In other proposals, a rate of return is imputed to assets and treated as income for purposes of determining welfare benefits. Under this later approach, owners of substan­tial assets might receive reduced benefits but still partici­pate in the welfare program.

Treatment of assets is an important issue for self­employed persons, particularly those engaged in busi­nesses which require substantial capital outlays. The extent to which self-employed families can participate in a particular welfare programs may depend heavily on the

1 0 Most current or proposed public assistance programs with direct asset limits exclude all or a portion of an owner-occupied house and personal effects. Most current welfare programs such as SSI plac.;c a limit on the nonbusiness assets a recipient may have but place no limit on the amount of business assets.

specific rules for handling business assets. Under a par­ticularly "strong" asset test, operators of small- and medium-sized businesses, who temporarily have low incomes and, for some reason, are unable to obtain emergency business assistance from the Federal or State Government, would be excluded from receiving welfare benefits. This implies that some businessmen would have to to dispose of their means of livelihood before public assistance could be offered. For some temporarily poor businessmen, disposing of the business also involves disposing of the family dwelling. A "liberal" asset test, particularly with respect to business assets, would allow a welfare system to operate as an income insurance pro­gram for the self-employed by guaranteeing a minimum family income without forcing business liquidation.

A recent study illustrates the importance of the asset test to holders of business assets (6). Income-producing assets such as farm business are not considered under the eligibility criteria for the current SSI program. A recent welfare reform proposal would have modified the SSI program to, among other changes, impute a rate of return to business assets to be treated as unearned income for purposes of determining SSI benefits (9). The analysis of the effects of this proposed program change showed about 12 percent fewer farm families eligible for SSI benefits, primarily as a result of the change in the asset test ( 6). Thus, strengthening the asset test can have a substantial impact on welfare program eligibility among farm owners.

As the PBJI is currently drafted, recipient's nonbusi­ness assets may not exceed $5,000, and business assets may not exceed a limit to be set by the Secretary of HEW ( 7). The total value of owner-occupied housing, household goods and personal effects, and the reason­able retail value of a nonbusiness vehicle are excluded from countable assets. For those who would be eligible to participate in PBJI by meeting these asset limits, a rate of return is imputed to their assets and treated as unearned income for purposes of determining benefits. The imputed rate of return is 15 percent to nonbusiness assets and I 0 percent to equity in business assets.

The selection of accounting period can also affect the composition of the eligible population. The longer the accounting period, the Jess likely it is that families, who regularly experience fluctuating (but high-average) incomes, will receive welfare benefits. Current welfare programs (AFDC, Food Stamps, and SSI) use a prospec­tive accounting period; benefits are based on the appli­cants anticipated income over the next I to 3 months, depending on the program. Such a prospective account­ing period increases the probability that families can anticipate--but not necessarily experience-low incomes and still be eligible to participate in welfare programs. PBJI, as currently drafted, utilizes a 6-month retrospec­tive accounting period. Benefits are based on the actual income received by the family over the previous 6 months.

A 1977 study by Steuerle and McClung illustrates the

impact of the accounting period on the composition of the eligible welfare population (14). The study shows that the longer the income accounting period, the smaller the poverty population under a given poverty criteria. While all socioeconomic groups showed an increase in the number of poor as a result of a shorter accounting period, the smallest change occurred among groups with a larger percentage of steady low-paying jobs. Shortening the accounting period had the most dramatic impact on the number of self-employed con­sidered as poor. For example, using one definition of poverty, 8.7 percent of all self-employed persons were poor in 1972 (14, table 2). However, using the same definition but a 5-year average estimate reduced the incidence of poverty among the self-employed to 3.4 percent, Jess than half that for the shorter accounting period. Steuerle and McClung note that under a public assistance program with fixed funding, decreasing the accounting period alters the shares of assistance going to different socioeconomic groups with the long-term poor receiving a smaller share as the accounting period is shortened. Under programs with open-ended funding (all who are eligible can receive benefits), a shorter account­ing period increases the total program costs.

The definition and measurement of self-employment income is important in determining eligibility for welfare programs. Self-employment income, unlike wages or interest and dividends, represents both returns to labor and capital inputs. As yet, no satisfactory procedures has been devised to partition self-employment income between returns to labor and capital. If self-employment income is treated as labor income and returns are imputed to capital for purposes of determining program eligibility, then clearly, capital income is double­counted, and concomitantly, countable income is over­stated. Similarly, countable income is understated if self-employment income is treated as returns solely to capital. The latter approach would result in a larger participation rate among the self-employed.

An ideal way of measuring self-employment income for determining welfare benefits would utilize the accrual accounting method. Accrual accounting mini­mizes the ability of potential eligibles to adjust business inventories to accommodate the income accounting period. But, many farmers and other small businessmen utilize the cash accounting system. And indigent, self­employed persons may not have the necessary skills to maintain an accrual accounting system. The Rural Income Maintenance Experiment (RIME) overcame this problem by establishing a carryover provision whereby income in excess of the level at which welfare benefits were reduced to zero was carried forward and added to income in any subsequent period in which the family's income fell below its break-even level (19, p. 84).

Underreporting of income is also a significant meas­urement problem associated with welfare program administration. When dealing with farm families, the RIME found that underreporting of income and assets

17

was widespread (1 9). This underreporting could enable many farm families to receive benefits who were over the break-even level and caused overpayments in general. This underreporting was so extensive that it was deemed potentially more costly to a permanent program's budget than work reduction (1 5). Part of the under­reporting problem might be associated with low-educa­tion levels among experimental household heads. Most families had difficulty understanding the details of the experiment, such as basic benefit levels, implicit tax rates, etc. Many had difficulty reading, and some could not write more than their names.

Welfare Reform and Work Incentives

In any discussion of welfare reform, one question always looms large. Will a guaranteed annual income have an adverse effect on the work incentives of the poor? Several social experiments, designed to test this question, have been run in both urban and rural areas (18, 19).

RIME, conducted by the Institute for Research on Poverty, University of Wisconsin, for the U.S. Depart­ment of Health, Education, and Welfare, was adminis­tered to 809 families in Iowa and North Carolina to test the effect of a broad-based cash assistance program on rural poor families. 11 The sample was divided into experimental groups who received payments and a con­trol group who did not. The sample was designed to include nonaged, male-headed households; nonaged, female-headed households; and aged-headed households of either sex. The male-headed households were almost equally divided between the self-employed (farmers and other businessmen) and wage earners. The results reviewed here are limited to male-headed households, the group of most policy interest since they are cur­rently excluded from AFDC in most States.

For male-headed, wage-earner families in the experi­mental group, total family income was 13 percent lower than that of the same type family in the control group (1 9). This difference was due mainly to the decrease in employment (approximately 28 percent) by experi­mental group wives. Hours worked decreased only slightly for husbands compared to the control group, a difference which was not statistically significant. There was also a significant decrease in hours worked by experimental group dependents.

Farm families in the experimental group also had lower total family income than their counterparts in the control group (1 9). This difference was caused by the decrease in nonfarm wage work by both husbands and wives in the experimental group. Although farm opera­tors decreased nonfarm wage work, they did show a nearly 1 0-percen t increase in hours devoted to farm work. This increase in hours worked, however, did not

1 1 The following results of RIME arc taken from the Sum­mary Report (19).

18

result in significant increases in farm output. Actually, farm output declined for the experimental group relative to the control group. Thus, farm income did not increase to offset the decrease in earnings from nonfarm wage work. The increase in hours worked by experimental farm operators on the farm-combined with a reduction in farm output-resulted in a reduction in technical effi­ciency (output per unit of variable input). There is no clear explanation of why this occurred. Perhaps farm operators were holding farm output for future sale after the experiment, or the additional hours worked were devoted to their own account capital formation.

PBJI is designed to provide strong incentives to work (1 7). Those family heads and individuals expected to work are provided lower cash assistance, but receive a substantial earnings disregard (the first $3,800 of earned income) before the benefit reduction rate (50 cents for each dollar of earnings) becomes effective. If they refuse a job or training, singles and childless couples are no longer eligible for benefits. If the principal wage earner in a family refuses to work, his or her benefits are cut off, but benefits to other family members are con­tinued to prevent them from becoming destitute.

To assure that principal wage earners in two-parent families have the opportunity to work when private­sector jobs are not available, State and local Govern­ments are encouraged to create public-service jobs which would be financed by the Federal Government. To the extent possible, these jobs would provide train­ing for private-sector employment. These public-service jobs would serve only as temporary employment and are purposefully designed to be less profitable. As an incentive for participants to find private-sector occupa­tions, the jobs would pay only the minimum wage and earnings derived would not qualify for the Earned In­come Tax Credit.

A major aim of the Administration's proposal is to help participants learn marketable job skills (1 7). In most cases, these skills reflect job opportunities within the local private-sector labor market. Rural labor mar­kets, in comparison to urban areas, generally possess fewer alternative occupational opportunities. Concur­rently, there are likely to be fewer employment oppor­tunities for persons possessing specific job skills. Thus, the structuring of rural public service employment pro­grams is considerably more critical and difficult than in urban areas if the program is to achieve its objectives.

Concluding Comments

Welfare reform is a national issue directly affecting people living in rural areas, particularly in the South. If the Administration's PBJI proposal is adopted, a sub­stantial number of rural families will be eligible for wel­fare benefits. The present welfare system's regional and residential disparity in average payments would be con­siderably reduced with national benefit levels. As the

proposal is refined and developed, particular a_ttention should be given to specific provisions which dtrectly affect rural residents, particularly the self-employed.

These include asset tests, income accounting procedures, and implementation of the public-service employment program.

APPENDIX

Overview of Current Welfare System

The PBJI program calls for terminating the AFDC, Food Stamp, and SSI programs. The AFDC program was enacted in 1935 to encourage the care of dependent children in their homes or in the homes of relatives by enabling each State to provide federally fmanced assist­ance (8). Since its inception, AFDC has been expanded from providing assistance only to needy children deprived of parental support to providing ~ove~age to a needy parent or relative with whom the child lives and, finally, to providing optional coverage to a second parent if that parent is incapacitated or unemployed (currently, 27 States provide such coverage). In 1967 a work maintenance program (WIN) was initiated to pro­vide training and employment services to AFDC partici­pants. In 1972 registration in WIN was made mandatory for all AFDC recipients defined as employable.

The Department of Health, Education, and Welfare administers AFDC grants to the States which in turn administer the program either through district or county offices or through local agencies. On the average, the Federal Government pays 55 percent of direct financial assistance to participants with States (or in some cases, State and local governments) paying the remaining 45 percent.

In order to receive benefits under AFDC, categori­cally eligible families must pass assets and income tests. These tests are specified by the individual States and consist of maximum assets and income levels which set the ceiling for families to qualify for assistance. States also establish their own "needs standards" as a basis for determining payments. The needs standard covers basic clothing, food, and shelter costs and varies by family size and other factors. However, States are not required to pay up to the full needs standard, and the proportion paid to eligibles varies from State to State. For example, the following amounts would be paid to a family with four recipi:ents in these selected States in July 1976: 12

Largest payment State Needs

I standard Percent of Amount needs

Mississippi ..... $277 $60 22 Missouri ....... 365 170 47 Ohio .......... 431 254 59 Idaho ....•.... 395 344 87 New York ...... 422 422 100

1 2 Source: Department of Health, Education, and Welfare. Aid to Families with Dependent Children, July 1976, DHEW Publication No. (SRS) 77-03200, Feb. 1977.

In 1970 approximately 9.7 million recipients partici­pated in the AFDC program, and total money payments, including State payments, were $4.8 billion (21). By 1975 the number of recipients had increased to 11.4 million (by 17.5 percent) and total payments to $9.2 billion (by 91.7 percent) (21).

The Food Stamp program was established in 1964 to improve the diets of low-income households and expand the market for domestically produced food by supple­menting the food purchasing power of eligible low­income households (8). When enacted, the program was available to all counties which wished to participate. By 1973 participation by all counties was made mandatory.

Eligibility standards and benefits of Food Stamps are nationally uniform. Eligibility covers any household, in­cluding intact families with a working member, single adults, and childless couples, which meets the assets and income tests. Households where all members receive public assistance are categorically eligible for Food Stamps. A household with no net income is eligible for Food Stamps at no charge. As income rises, the house­hold is required to pay increasing amounts for Food Stamps, with the value of the coupons above the pur­chase price being the bonus or benefit received. Purchase requirements, however, cannot exceed 30 percent of household income. 13 To be eligible for Food Stamps, unemployed household members must also be registered for work.

The Food Stamp program is administered by the Department of Agriculture through State and local wel­fare offices. The Federal Government funds 100 percent of the benefits to households and approximately half the administrative costs of the program. In 1970 an esti­mated 4.3 million persons participated in the Food Stamp program, and the program's benefits totaled $0.549 billion (1 5). By I 97 5 participation had grown to over I 7 million (by 295 percent) and total benefits to $4.395 billion (by 700 percent) (10). Approximately two-thirds of the households receiving Food Stamps receive benefits from other public assistance programs; 42 percent of the program's participants in 1975 were AFDC families (1 3).

The Supplemental Security Income Program (SSI), initiated in January I 974, was established to provide a nationally uniform minimum cash income to aged, blind, and disabled individuals who had previously been receiv­ing assistance through State-administered programs. In 1970, 3.1 million participants received $2.9 billion in

1 3 At the time this article was prepared (August 1977) the Administration had proposed and Congress was considering legislation which would abolish Ihc purchase requirement.

19

benefits under the former State-administered programs for the aged, blind, and disabled (22). In 1975, $5.9 billion was provided to over 4.3 million SSI recipients (22).

SSI is administered by the Social Security Adminis­tration through its regional and district offices. To be eligible for SSI benefits, individuals or couples must meet the Social Security Act definition of either aged, blind, or disabled. Their income and assets, after certain exemptions, must be below the maximum levels speci­fied in the SSI means test. Maximum benefits are paid to

those with no income, and benefit levels are reduced in relation to the amount of countable income for those with either earned or unearned income. Along with federally funded SSI, the States are permitted to make supplementary payments to all SSI beneficiaries. 14

1 4 For those who had been receiving payments under the State programs for the aged, blind, and disabled, States are required to supplement SSI benefits if they are less than the previous benefits. State supplements to new beneficiaries, however, are optional.

LITERATURE CITED

(1) Abt Associates, Inc. Appendix to the Budget of the U.S. Govern-The Causes of Rural to Urban Migration Among ment, Fiscal Year 1977. 1976. the Poor, March 31 , 1970. (11) Hines, Fred K., and Max F. Jordan

(2) Barth, Michael C., George J. Cargagno, and John L. Welfare Reform: Benefits and Incentives in Palmer Rural Areas. ERS-470. U.S. Dept. Agr., Econ.

Toward an Effective Income Support System: Res. Serv., June 1971. Problems, Prospects, and Choices. Institute for (12) Long, Larry H. Research on Poverty, Univ. of Wisconsin- "Poverty Status and Receipt of Welfare Among Madison, 1974. Migrants and Nonmigrants in Large Cities,"

(3) Beale, Calvin L. Amer. Soc. Rev., Vol. 39, Feb. 1974, pp. 46-56. "A Further Look at Nonmetropolitan Popula- (13) Merck, Carolyn, and Stephen A. Schroffel tion Growth Since 1970," Amer. Jour. Agr. Characteristics of Food Stamp Households. Econ., Vol. 58, No.5, Dec. 1976, pp. 953-958. FNS-160. U.S. Dept. Agr., Food and Nutrition

(4) Serv., May 1976. "Rural-Urban Migration of Blacks: Past and (14) Steuerle, Eugene and Nelson McClung Future," Amer. Jour. Agr. Econ., Vol. 53, No. Wealth and the Accounting Period in the 2, May 1971, pp. 302-307. Measurement of Means. Techn. Paper VI. The

(5) Carlin, Thomas A. Measurement of Poverty. U.S. Dept. Health, Impact of Earned Income Tax Credit: A Simu- Education, and Welfare, Feb. 1977. lation of Tax Year 1976. AER-336. U.S. Dept. (15) U.S. Department of Agriculture, Econ. Res. Ser. Agr., Econ. Res. Ser.,June 1976. Agricultural Statistics, 1975.

(6) , Gary Hendricks, and Faye F. (16) U.S. Department of Health, Education, and Wei-Christian fare, Office of Economic Opportunity

Residential and Regional Distribution of Bene- The Changing Economic Status of 5,000 fits Under the Allowance for Basic Uving Ex- American Families: Highlights from the Panel penses (ABLE) Welfare Reform Proposal. Study of Income Dynamics, May 1974. AER-374. U.S. Dept. Agr. in cooperation with (17) Urban Institute, June 1977. HEW News, August 6, 1977.

(7) Congress of the United States, House of Repre- (18) sentatives. New Jersey Graduated Work Incentive Experi-

H.R. 9030, Better Jobs and Income Bill, 94th ment. Summary Rpt., Dec. 1973. Congress, 1st Session, Sept. 12, 1977. (19)

(8) Congress of the United States, Joint Economic Rural Income Maintenance Experiment. Sum-Committee, Subcommittee on Fiscal Policy mary Rpt., Nov. 1976.

Handbook of Public Income Transfer Pro- (20) , Social Security Administration grams: 1975. Studies in Public Welfare, Paper Social Security Bulletin, Vol. 39, No. 5, May No. 20, Dec. 31, 1974. 1976.

(9) (21) Income Security for Americans, Recommen- Social Security Bulletin. Vol. 39, No. 11, Nov. dations of the Public Welfare Study, Dec. 4, 1976. 1974. (22)

(10) Executive Office of the President of the United Social Security Bulletin. Vol. 40, No. 2, Feb. States, Office of Management and Budget 1977.

20

Cost of Capital for American Agriculture: Its Use in Agricultural Policy Formulation

Fred C. White, Wesley N. Musser, and Johannes Oosthuizen'

The Agricultural and Consumer Protection Act of 1973 established target prices for basic commodities and provided for deficiency payments to producers when the market price was below the target price. The Act directed the Secretary of Agriculture to prepare annual estimates of the cost of production of basic commodities (1 6) to be used as a policy input for future adjustments of target prices (14, pp. v-vii). Pursuant to this provision, the Economic Research Service developed methodology and collected data to estimate the cost of production for major crops in various production regions (14).

The major methodological problems include costs of labor, management, and land. The costs of these inputs are particularly difficult to estimate because they are usually provided by farm families rather than purchased in the market. Since market prices do not exist for these specific productive services, prices of similar inputs are used as a proxy for these inputs (7).

Equity capital is another input service largely pro­vided by farm families which has not generated similar methodological concern. In part, this neglect reflects the legislative provisions mandating the cost of production analysis: the Act stated that the charge on fixed capital should equal current interest rates of the Federal Land

Bank (14, p. vii). The lack of concern about this method also reflects its widespread use in enterprise budgeting analysis io farm management research and extension. Despite the acceptance in farm budgeting of interest rates as a charge for equity capital, this method is in con­flict with modern financial theory. In corporate finance theory, the concept of the weighted average cost of capital rather than the interest rate on debt is used to reflect costs of financial capital. The limited literature on the application of this concept to agriculture indi­cates that it has theoretical merit over traditional methods but that empirical application has been limited (2, pp. 252-256; 4, 5, 6).

The purpose of this paper is to consider the merits of the concept of cost of capital as an alternative to interest rates in aggregate policy analysis. Specific objectives include: (I) Consideration of the theoretical merits of the two methods, (2) development of methods appropri­ate for estimation of the cost of capital for agriculture, (3) estimation of the cost of capital for U.S. agriculture with aggregate data and evaluation of weaknesses of these estimates, and ( 4) evaluation of the empirical dif­ferences between the two methods.

CONCEPTUAL FRAMEWORK

Rates of return on investments are typically con­ceived as having four components: A pure, risk-free interest rate, a risk premium, a liquidity premium, and a management fee. The risk-free interest rate is deter­mined by the aggregate supply and demand for money in the economy and is measured by yields on U.S. Gov· ernment securities. The risk premium is in recognition that most investors are risk-averse and therefore require a higher rate of return to assume risk. The liquidity pre­mium follows from Keynes' concept of liquidity prefer-

1 The authors are associate professor, assistant professor, and graduate assistant, respectively, Department of Agricultural Economics, Univ. of Georgia, Athens, Ga.

ence: investors require a premium on investments for which established markets do not exist. Finally, invest­ments that require more management effort will gener­ally require a higher return.

In application of these concepts to firm finance, the rate of return in the form of cash payments and/or in­creases in value that investors receive on different forms of financial capital are considered the costs of these forms to the firm. With competitive financial markets, security prices reflect the different rates of return neces­sary to compensate investors for the differences in risk, liquidity, and management for the securities.

An important generalization about these differences in costs of different forms of capital is that equity capi­tal has a higher cost than debt capital. These differences

21

primarily reflect a premium for the greater risk associ­ated with an ownership rather than a lender position. A lender is subject to less variability in annual returns since he is guaranteed an interest payment rather than receiving the residual profits. Furthermore, lenders are subject to less risk of capital loss than equity owners because they have first claim on assets in the case of bankruptcy.

This important financial generalization is the main methodological weakness in calculation of the cost of capital assets for agriculture with an interest rate on debt. While this rate is appropriate for the component of assets which are financed with debt, application of this rate to the portion of assets financed with equity capital fails to include a risk premium to compensate equity holders for the risk of ownership of farm assets.

In the context of agricultural policy analysis, the existence of price supports reduces the magnitude of risk of ownership since price supports reduce or eliminate the price risk of basic commodities. However, the owner of farm assets is still subject to yield uncertainty under current and most forms of agricultural supports. Only under a farm program that would guarantee gross income per unit of production would the risk of ownership be no higher than that of lenders. Under current agricultural policy, the method of costing equity capital fails to in­clude compensation for risk and therefore could under­state the total cost of production.

A major problem in applying the theoretical propo­sitions of corporate finance theory to cost of agricultural production concerns the estimation of equity capital. The problem with estimation of the cost of equity capital is that markets akin to the stock market do not exist for equity capital supplied by owners of farm assets.

One approach is to use an opportunity cost for these investments, using returns on alternative uses of the equity capital. However, this approach is fraught with methodological weaknesses in identifying market rates with similar risk, liquidity, and management character-

istics. In addition, owners of small, owner-managed firms may be willing to accept lower returns on their invest­ment than alternative investments with comparable risk in order to be self-employed. For agriculture, this latter position can be supplemented with consumption attri­butes of farm life. The approach reflects the competitive market position that these investors would not continue to employ their capital in agriculture if the returns that they were receiving did not compensate them for their particular investment characteristics.

In estimation of cost of equity capital for small firms, the major problem is estimation of value of equity. Cash flow returns are available from accounting records. How­ever, markets to value firm equity do not exist so that the investment of equity owners and the returns due to appreciation in equity value are difficult to estimate. In the context of agribusiness firms, Smith and Cooper ( 8) note that the only market values which can be established are liquidation and replacement values which are based on the market value of tangible assets. However, they reject these methods as valid measures because intangible assets also are important to these firms and some of the tangible assets are highly specialized with limited markets (8, pp. 191-196). These limitations are not so applicable to most farm firms because their assets are less specialized to a particular firm and the undifferentiated nature of farm output reduces the importance of intangible assets. Thus, the value of equity can be estimated by subtracting liabilities from market value of farm assets.

Another aspect of the cost of capital approach is that this cost factor covers investment and management costs associated with the farm business. A valid estimate of cost of capital therefore includes a management charge which eliminates the need to define a separate opportun­ity cost for management. Furthermore, this approach does not require a separate charge for land. Land, physi­cal capital, and operating capital are all specific compo­nents of the financial capital invested in the farm which are all subject to a cost of capital.

THE MODEL

In general terms, the cost of capital is the component cost of each capital source represented in the firm's capital structure weighted according to its level of use. Two general sources are the balance sheet categories of debt and equity. For the purpose of this paper, debt cap­ital is capital obtained from sources other than the firm's owners. Examples of debt are bank term loans, loans from various other credit agencies, and other such arrangements. Equity is capital invested by the firm's owners. In practice, it can either be funds directly in­vested by the owner or earnings retained in the business.

In estimating the component cost of each type of capital, it is necessary to consider not only the explicit

22

cost of capital but also any implicit costs which can be reliably estimated. In the case of debt, the explicit cost is simply the effective interest associated with the debt. Alternately this cost can be stated as the yield on such debt to rna turity when calculated on the basis of the actual amount of money received by the firm. Since interest payments are tax deductible, the true cost of debt will be lower than its effective before-tax cost. Thus, the cost of debt can be represented as follows:

Ko=Eo(l-T) (I)

where

Ko is the cost of debt, Eo is the effective interest rate, and T is the tax rate applicable to the firm.

If the cost of capital is used as a decisionmaking tool, the effective interest rate on new debt is utilized rather than rates on debt the firm may have raised in the past.

Cost of the equity component of capital poses more estimation problems than debt. Despite the absence of any explicit cost such as interest, the cost of equity does have a real cost. Conventionally, the cost of equity capi­tal is defined as the rate of return that must be earned on economic activity financed with equity in order to maintain the value of current equity. Consistent with this definition, this cost is estimated as the return to net worth presently earned by the firm. Since returns in farming fluctuate from year to year, the cost of equity can best be observed over a period of several years. In this paper, a 5-year average is used as an estimate of the cost of capital. This return is not presently reported directly but can be calculated by combining specific data series as indicated below.

In calculating the returns to equity, the after-tax income must first be adjusted for unpaid factors of pro­duction other than capital. The most important unpaid factor of production in farming is family labor. An opportunity cost to family labor was estimated as the product of the wage rate and hours of family labor and was subtracted from profits to obtain cash returns to equity. A final adjustment is necessary to represent both implicit and explicit returns to farming.

Land assets contributetto explicit returns in the form of cash receipts and in addition earn a return in the form of land value appreciation. Similarly, investments in stocks and other securities have been earning the sum of these returns. Therefore, both income flows and value changes must be reflected in the cost of equity. This implicit return must be adjusted by the amount of capi­tal gain taxes to which the increased land value would

subject the owners if the gain were actually realized. Thus, the rate of return to net worth and cost of equity capital can be represented as follows:

where

NP - 0 L + LV (1-T c)

NW

KE is the cost of equity capital, NP is net profits after taxes, OL is operator and family labor, LV is the total amount of increase in land value, T cis appropriate capital gain tax rate, and NW represents net worth.

(2)

After the determination of each component cost (Ko and KE), the weighted cost of capital can be determined by assigning a weight equal to the current use of debt and equity in the firm's capital structure. Combining equations (1) and (2), the weighted cost of capital will be:

(3)

where

Ko is the weighted cost of capital, and

i is the equity-asset ratio defined by the current cap­ital structure.

Since the values used in calculation of Ko were not deflated, the estimate of Ko includes the effect of infla­tion. This procedure is theoretically correct if the cost of capital is to be used in analytical situations in which cap­ital values are not deflated. If capital values are in real terms, the data used in equations (1) and (2) should also be deflated (I, pp. 83-94 ).

DATA

The average cost of capital for farming was calculated for the United States during the period 1960-75. The basic data used in the analysis were from the United States Department of Agriculture, Economic Research Service (ERS) publications.

Average interest rates for farm loans were obtained from Agricultural Finance Statistics (I 2) and Agricul­tural Finance Review (10, 1 1). Net farm income and off-farm income were obtained from Fann Income Sta· tis tics (I 5). The particular farm income estimate used was average cash net farm income adjusted for changes in inventory and home consumption. In calculating the income tax rate, the value of farm production con­sumed directly in farm households and gross rental value of farm dwellings were subtracted from total

income (net farm income plus off. farm income), because these items are not subject to taxation. Average income per farm exclusive of these nontaxable items was used to calculate the marginal tax rate. This rate was then used in calculating the cost of debt.

The Balance Sheet of the Fanning Sector (13) pro­vided estimates of the average value per farm of real estate, total assets, total liabilities, and proprietors' equities. These estimates were used to calculate land value appreciation and equity-asset ratios. The marginal capital gains tax rate appropriate for land value apprecia­tion was calculated after combining net farm income, off-farm income, and land value appreciation.

The value of unpaid family and operator labor was calculated using farm labor expenditures from Fann

23

Income Statistics (I 5); and total hours used for farm­work and average wage rate for farm labor from Agri­cultural Statistics (9). Total value of labor used in farm­ing was estimated as the product of average wage rate and total hours used for farm work. The value of unpaid family and operator labor was calculated as the differ­ence between total value of labor used in farming and expenditures for hired labor.

The cost of capital was also estimated for various sizes of farms for a single point in time -the year 1970. The data and procedures for calculating various com­ponents were similar to those described above. However,

the major data source for these calculations was Returns to Equity Capital by Economic Class of Farms (3). There were slight differences in the data used in the time series and cross-sectional analyses. For example, the 1970 data series on net farm income did not include home consumption, but assets used in producing items for home consumption had been deducted from total assets. Thus, the average cost of capital calculated in the crosssectional analysis for 1970 would not be expected to be identical to the cost of capital for 1970 calculated in the time series analysis.

RESULTS

Aggregate Estimates

Selected aggregate estimates used in calculating rate of return on equity or net worth for the period 1960-75 are presented in table 1. Equity per farm increased almost 3.5 times during the IS-year period. Equity in­creased moderately, $3,000 to $6,000 annually, up to 1971, but since 1971 it has increased at a much faster rate. It increased almost $30,000 between 1973 and 1974, primarily as the result of rapid land value appre­ciation. Prior to 1970, land value appreciation accounted for less than half of the increase in equity. However, since 1970, land value appreciation has accounted. for a substantial portion of the increase in equity per farm.

Net profits per farm also showed a moderate upward trend through 1971 but never exceeded $5,000 per farm. Net profits peaked at $9,358 in 1973, declined in 1974, and declined further in 1975. With farmers experi­encing an increase in both equity and net profits, the rate of return on equity exceeded 8 percent in 1965 and I 966 and declined until I 970. The highest return on

equity, of course, occurred in 1973 when net profits and land value appreciation were at their peaks. However, it is not expected that farmers would make long-term

capital investment decisions based on returns of a single year. Hence, the cost of equity reported in this study is a 5-year average.

Selected components used in the calculation of the cost of capital for U.S. farmers are shown in table 2. The equity-asset ratio has shown only moderate fluctuations over the period of the study. Shifts in the equity-asset ratio can be explained by two factors: (1) the relative cost of equity and debt, and (2) land value appreciation. Land value appreciation alone would have substantially increased the equity-asset ratio of farmers. However, the fact that debt has been relatively cheaper than equity capital is reflected in the tripling of total debt between I 960 and 1975 (I 3). The nedmpact of these two factors on the equity-asset ratio has resulted in a gradual downward trend in the ratio through 1970 and then an upward trend since I 970. The cost of debt capital was low relative to equity capital until I 970, resulting in an

Table 1-Cost of equity components for U.S. farmers, 1960-75

Operator and Land value Year Equity per farm Net profits family labor appreciation Return on 5-year average

E NP OL LV(1·Tc) equity cost of equity

.......... Dollars 0 0 0 0 0 0 0 0 0 0 0 0 0 Percent 0 - 0

1960 ...... 0 •••• 0 0. 0 •••• 45,218 2,773 1,625 374 3.36 1961 . 0 0. 0 0 0. 0 •• 0 ••••••• 46,693 2,979 1,598 1,502 6.17 1962 0 0 0 0. 0 0 0. 0 •••••• 0 •• 50,054 3,024 1,563 1,473 5.86 1963 0. 0. 0 0 ••• 0 •• 0 •• 0 ••• 53,359 3,030 1,595 2,140 6.70 1964 .... 0 •• 0 ••••••• 0 •• 0 56,523 3,164 1,553 2,348 7.00 5.82 1965 0 •• 0. 0 0 ••••••• 0 •••• 59,952 3,391 1,419 3,059 8.39 6.82 1966 .... 0 0. 0 •• 0 ••• 0 ••• 0 65,705 4,088 1,461 2,658 8.04 7.12 1967 ... ·'· 0 •• 0. 0 •••••••• 70,683 3,526 1,632 2,938 6.85 7.40 1968 ........ 0 •••• 0 •• 0 •• 76,066 3,770 1,736 2,627 6.13 7.28 1969 .......... 0 ••• 0. 0 0 0 81,627 4,445 1,819 1,615 5.20 6.92 1970 ... 0 ••••••• 0 ••••••• 85,714 4,486 1,849 2.444 5.93 6.43 1971 0 0 0 0 ••••••• 0. 0 0 ••• 0 90,512 4.270 2.008 5.104 8.14 6.45 1972 .... 0 0 •• 0. 0 ••••• 0 0. 99,024 5,726 2.028 8,768 12,59 7.60 1973 .... 0 •••• 0 0 •• 0 ••••• 113,361 9,358 2,102 19,541 23.64 11.10 1974 ........ 0. 0 ••••• 0. 0 142,120 8,807 2,345 14,084 14.46 12.95 1975 .. 0. 0 ••••••••••••• 0 156,268 7,394 2,289 15,861 13.42 14.45

24

Table 2-Cost of capital components estimated for U.S. farmers, 1964-75

Year

1964 ............................... . 1965 ............................... . 1966 ............................... . 1967 ............................... . 1968 ............................... . 1969 ............................... . 1970 ............................... . 1971 ............................... . 1972 ............................... . 1973 ............................... . 1974 ............................... . 1975 ............................... .

Assets per farm

Dollars

66,474 70,918 78,201 84,630 91,501 98,466

103,656 109,212 119,616 136,357 168,303 185,398

'Cost of equity (KE) is reported as a 5-year average.

increase in the use of debt relative to assets and hence a decline in the equity-asset ratio. Since 1972 the cost of debt has again been low relative to the cost of equity, however, the rapid land value appreciation has increased farmers' equity level relative to debt, hence the upward trend in the equity-asset ratio.

The cost of capital was calculated for each year using equation (3) and the estimates for equity-asset ratio, cost of equity, and cost of debt reported in table 2. The cost of capital increased from 5.7 percent in 1964 to 7.1 percent in 1967 and then decreased to 6.5 percent in 1970 and 1971. Since 1971 the cost of capital has increased an average 1.7 percentage points each year.

Aggregation Error

Calculating the cost of capital for the average farm situation may introduce aggregation error, i.e. this estimate might differ significantly from that obtained by averaging individual cost of capital estimates. Hence, this section will explore the potential for aggregation error through a cross-sectional analysis.

Financial components used in the calculation of cost of capital for farms by economic class are presented in

Equity-asset ratio (E/A)

Cost of equity' KE

Cost of debt Ko

Cost of capital Ko

· · · · · · · · ·······Percent---·---········

85.0 84.5 84.0 83.5 83.1 82.9 82.6 82.8 82.8 83.1 84.4 84.3

5.8 6.8 7.1 7.4 7.3 6.9 6.4 6.5 7.6

11.1 13.0 14.5

5.2 5.1 5.0 5.4 5.6 5.7 6.9 6.8 6.0 5.5 6.7 7.3

5.7 6.6 6.8 7.1 7.0 6.7 6.5 6.5 7.3

10.2 12.0 13.3

table 3. In general, the effects of the cost of equity and cost of debt on equity-asset ratios evidenced in the time series data are also evident in this table. Larger farms (in terms of farm sales) have lower equity-asset ratios be­cause equity capital is relatively more expensive than debt capital. The reason for this relationship is that large farms are generally more efficient and hence more prof­itable. Thus, their cost of equity is higher, but their in­come tax rate is also higher. Since interest is tax deducti­ble, a higher tax rate means that the cost of debt is lower on large farms. For example, on class Ia farms the cost of equity is 8.1 percent compared to a cost of debt of only 4.0 percent.

The cost of capital for the smallest farms (classes V and VI) is negative because of the negative cost of equity and heavy dependence on equity capital as evidenced by their relatively high equity-asset ratios. The cost of capi­tal increases with farm sales to class lb. Class Ia farms have a slightly lower cost of capital which results from progressive income taxation. Farms in class Ia would exhibit a higher return on equity on a before-tax basis than class lb farms. The fact that this relationship is reversed on an after-tax basis indicates the importance of considering income taxation in these calculations.

Table 3-Cost of capital components by economic class of farm in the U.S., 1970

Economic class category Assets

per farm

1,000 dollars

Class Ia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 726.7 Class lb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263.8 Class II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160.0 Classlll.............................. 102.9 Class IV.............................. 64.7 Class V . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44.7 Class VI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25.4 All farms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86.8

Equity-asset ratio (E/ A)

Cost of equity (KE)

Cost of debt !Kol

Cost of capital (Kol

· · · · · · · · ·······Percent··-·--·-·······

74.1 8.1 4.02 7.04 78.4 9.0 6.16 8.39 82.3 8.1 6.67 7.85 82.6 6.8 6.93 6.82 85.8 3.8 6.93 4.24 91.1 ·2.6 7.18 -1.73 90.6 ·2.6 7.10 -1.69 82.7 6.0 6.93 4.96

25

Cost of capital calculations for the average of all farms is also presented in table 3. For 1970, the average cost of capital was 4.96 percent. To examine possible aggregation bias, the weighted average cost for all eco­nomic class categories was calculated and compared with the average for all farms. Weighting each category by total assets (or total capital investment) gives an average cost of capital of 5.48 percent. This estimate is slightly

higher than that obtained using only the average farm situation. Hence, using a more disaggregated approach than the average farming situation may be warranted when incorporating the cost of capital concept into policy decisions. However, it is expected that the gen­eral trends evidenced by data presented in this study would still hold.

COMPARISON WITH CURRENT PROCEDURES

The Federal Government presently uses interest rates of the Federal Land Bank and the Production Credit Association when computing charges for farm real estate and operating capital, respectively. This section compares current procedures with the cost of capital approach. Figure I shows movements in the cost of capital for U.S. farmers and the average interest rate of the Federal Land Bank over the past decade. It is interesting to note that these two rates do not generally move in the same direc­tion. Hence, the interest rate would not serve as a proxy for the cost of capital.

For illustrative purposes, the total cost of agricultural production in the United States was estimated using two approaches: First, the current Economic Research Serv­ice procedures (ERS); and second, the cost of capital (see table 4 ). The first step in both methods is to calcu­late total direct costs- the direct variable and fixed costs. These costs include purchases of feed, livestock, seed, fertilizer and lime, repairs and operations of capi­tal items, hired labor, depreciation, and property taxes. Beyond this point there are significant differences in the two methods.

Method A, the current procedure, calculates indirect total costs for management, unpaid family and operator labor, and capital charges on operating capital and land. The value of unpaid labor is simply the product of hours of such labor and the average wage rate. The manage­ment charge is based on normal management fees; ERS uses 7 percent of the value of production. To calculate operating capital for both methods, we have used total nonreal estate assets and one-third of direct costs. Method A uses the interest rate of the Production Credit Association as a charge on operating capital and the in­terest rate of the Federal Land Bank for real estate.

In calculating cost of capital no implicit charge for management was subtracted from net income. Hence, it is not necessary to incorporate a charge for management in Method B. The value of unpaid labor is calculated as in the first method. The only remaining step is to calcu­late a charge for capital investment using the cost of capital, Ko.

Method B (cost of capital) yielded a higher total cost of agricultural production in 1974 than Method A. How­ever, Method A provided the higher cost estimate in 1970. Contrasting the farming situations in these two production years gives us an insight into the implications

26

of using these two methods. Farm profits and produc­tion were higher in 1974 than 1970. Using interest rates on farm real estate and in addition imputing a manage­ment charge in estimating cost of production would tend to raise the estimate of the total cost of production dur-

Table 4-Estimates of cost of production for U.S. agriculture using two methods of calculation, 1970 and 1974

Cost items

Feed purchased ................... . Livestock purchased ............... . Seed purchased ................... . Fertilizer ........................ . Lime ........................... . Repairs and operation

of cap ita I items ................. . Hired labor ...................... . Depree iation 1 ••••••••••••••••.••••

Taxes on farm property ............ .

Total direct cost ............... .

Method A: Current ERS procedure Total direct cost ............... .

Unpaid family labor .............. . Management .................... . Interest on operating capital ....... . Land charge .................... .

Total indirect costs ............. .

Total costs ................... .

Method B: Cost of capital Total direct costs .............. .

Unpaid family labor .............. . Interest on operating capital ....... . Interest on land ................. .

Total indirect costs ............. .

Total costs ................... .

1970 1974

Million dollars

8,028 4,324

927 2,295

95

4,539 4,349 5,956 2,596

33,109

33,109 5,463 3,590 6,263

15,904

31,220

64,329

33,109 5,463 4,736

12,162

22,351

55,460

14,996 5,154 2,032 5,477

129

6,462 6,031 9,247 2,980

52,508

52,508 6,637 6,523

10,622 22,917

46,699

99,207

52,508 6,637

13,779 35,484

55,900

108,408

1 Depreciation and other consumption of farm capital­depreciation of farm operators' dwellings.

Source: U.S. Department of Agriculture, Economic Research Service, Farm Income Statistics, Stat. Bul. No. 547, Washington, D.C., July 1975.

ing periods of low profits in farming. Hence, target prices linked to cost of production during such periods would be higher with procedures used under the current program. However, during periods in which farm prices

FIGURE 1

were high and the Nation wanted to encourage addi­tional agricultural production, target prices would be higher if the cost of production were estimated with the cost of capital concept developed in this paper.

COST OF CAPITAL FOR U.S. FARMERS AND FEDERAL LAND BANK INTEREST RATES, 1965-75

PERCENT

15

12

9

3

Federal Land Bank interest rate

0~----~------~------~------L-----~~----~------~------~------~------J '65 '67 '69 '71 '73 '75

USDA NEG. ESCS-3003 78(11

EXTENSIONS

The estimates of cost of capital utilized to calculate the cost of agricultural production are illustrative of the potential of the concept rather than directly applicable to policy analysis. As the results for 1970 indicate, con­siderable aggregation error existed by class of farm at the national level. Undoubtedly aggregation error was also introduced due to regional differences in produc­tion risk, risk preferences, and financial organization. The cost of capital would, at the minimum, have to be estimated for each region in which a budget was to be prepared; estimation for different sizes of farms in the region would also reduce potential aggregation error. Finally, some consideration should be given to estimat­ing the cost of capital for each commodity: it is reason­able to expect that risk premiums would vary by com­modity due to varying production and price risk.

Implementation of this procedure in cost of produc­tion analysis would require collection of more data on

fmancial position of farmers, at least on the balance sheet items of assets, liabilities, and equity. Currently, annual estimates of these financial categories are availa­ble only at the national level. Estimation of these cate­gories at the production region level would be helpful. Such data could be collected in future national cost of production surveys.

Several of the methodological procedures utilized in this paper also need further research development. Cal­culation of the cost of equity as a simple 5-year moving average of rate of return on equity in this paper was arbitrary. Research on farmers expectations on rate of return may be useful in determining the appropriate method. In addition, the cost of capital varies with the level of production and/or the increase in production. Research on the relationship between these factors would be necessary to implement this procedure in a policy set tin g.

27

LITERATURE CITED

(1) Aplin, Richard D., George L. Casler, and Cheryl P. Francis

Capital Investment Analysis. Second Edition. Columbus, Ohio, Grid, Inc., 1977.

(2) Hopkin, John A., Peter J. Barry, and C. B. Baker Financial Management in Agriculture. The In­terstate Printers & Publishers, Inc., Danville, Ill., 1973.

(3) Hottel, J. Bruce and Robert D. Reinsel Returns to Equity Capital by Economic Class of Farm. Agr. Econ. Report 347. USDA. Wash­ington, D.C., August, 1976.

(4) Linke, Charles M. and John A. Hopkin "Financial Aspects of Growth in Agricultural Firms," A New Look at Agricultural Research. Proceedings of a Workshop. Finance Program Report No. 1. Univ. of Illinois, Dept. of Agr. Econ., 1970,pp.41-54.

(5) Musser, Wesley N., Fred C. White, and John C. McKissick

"An Analysis of Optimal Farm Capital Struc­ture," Southern Jour. of Agr. Econ., Vol. 9, No. I. (unpublished)

(6) Musser, Wesley N., and others "A Model to Calculate the Cost of Capital for Farm Firms," presented at Annual Meeting of American Agricultural Economics Association, Ohio State Univ., Columbus, Ohio, Aug. 10-13, 1975.

(7) Sharples, Jerry A. and Ronald Krenz

28

"Cost of Production: A Replacement for Parity?," Agr.-Food Policy Review. ERS

AFPR-1. U.S. Dept. of Agr., Jan. 1977, pp. 62-68.

(8) Smith, Frank J. and Ken Cooper The Financial Management of Agribusiness Firms. Special Report No. 26. Univ. of Minne­sota, Agricultural Extension Service, 1967.

(9) U.S. Department of Agriculture

(10)

(11)

(12)

Agricultural Statistics, 1976, U.S. Government Printing Office, Wash., D.C., 1976.

Economic Research Service, Agricultural Fi­nance Review. Vol. 27 Supplement, June 1967.

Agricultural Finance Review. Vol. 31, Supp., Dec. 1970.

Agricultural Finance Statistics. AFS-3, July 1976 and previous issues.

(13) Balance Sheet of the Farming Sector. Agr. Inf.

(14)

(15)

Bul. 389, Sup. No. 1, Apr. 1976.

Costs of Producing Selected Crops in the United States. Comm. on Agr. and For., U.S. Jan. 8, 1976.

Farm Income Statistics. Stat. Bul. 557, July 1976.

(16) U.S. Senate, 93rd Congress U.S. Public Law 93-36, "Agriculture and Con­sumer Protection Act of 1973," Aug. 10, 1973.

Identifying Growth Potential of Locally Owned Farmer Cooperatives

Gory T. Devino, Francis P. McComley, and Stephen E. Mathis I

Agricultural economists have placed considerable research emphasis on the financial aspects of the growth of farm firms (8). Much of this work has explicitly rec­ognized the role of capital accumulation in maintaining economically viable farm units. However, only limited work has been done on analogous problems faced by the local farm supply and marketing cooperative serving agriculture. Yet the performance of the farm firm is highly influenced by the performance of the firms from which it purchases supplies or which market its product.

For many of the locally owned farmer cooperatives that perform these functions, growth will be necessary if they are to continue serving their members effectively. Narrowing margins caused by the effect of inflation on costs makes expansion attractive in order to take advan­tage of size economies (2). Other incentives for growth include opportunities for expanding earnings and for providing a wider variety of products and services.

Whatever the incentives for expansion, there are cer­tain factors which determine potential. Some of these, such as the size of the trade areas served, the nature of competition faced, and the proximity to suppliers or terminal markets, are external to the firm and to a con­siderable degree beyond its control.

Other factors are more controllable by management. These include the organization structure and the human,

physical, and financial resources available to the firm. A complete analysis of a firm's strengths and weaknesses would require a management audit of all facets of its operation. Such an analysis could be time consuming and expensive.

However, because many of a firm's assets are trans­lated into dollars on the firm's financial statements, anal­ysis of its financial statements allows identification of the strengths and weaknesses of the firm. Knowing the financial relationships associated with growth enhances the analyst's ability to determine the potential for growth and to suggest changes needed in those firms with a resource base that will not support growth.

This paper reports results of research whose objec­tives were:

1. To select from among financial ratios used to measure growth in business firms the ratio which best identifies a locally owned farmer coopera­tive's ability to provide the facilities and services needed by its members.

2. To identify financial measures which have a strong relationship to growth in locally owned farmer cooperatives.

3. To formulate a model for identifying growth potential for locally owned farmer cooperatives.

USING FINANCIAL RATIOS AS PREDICfORS

Financial ratios have long been used to predict busi­ness success, but the decisions about which ratios to use and what weights to assign to each ratio have commonly been made subjectively. Several recent studies which attempted to use fmancial ratios as predictors of business firm failure provided useful background in

1 Gary T. Devino and Francis P. McCamley are associate professors in the Department of Agricultural Economics, Univer­sity of Missouri, Columbia. Stephen E. Mathis is a loan supervisor for Farmland Industries, Kansas City, Missouri.

selecting sampling procedures and statistical techniques for this study.

Altman used multiple discriminant analysis to predict corporate bankruptcy. His model, which utilized four ratios, was accurate up to 2 years prior to bankruptcy. He was encouraged by the superior performance of the technique relative to the more common techniques of sequential ratio comparisons (1).

Edmister tested five different sets of variables as he used discriminant analysis to predict small business fail­ure. He found that averaging the information from three

29

consecutive financial statements gave a better discrimi­nant function than could be obtained from any single year. This averaging technique smoothed the ratios, pre­sumably giving more representative figures than could be calculated from only one statement. Edmister also noted that a small group of ratios predicted better than any single ratio, but ratios also tend to be related and thus

multi-collinearity was a problem (3). Elam used linear probability models to test the effect

of lease data on the probability of bankruptcy. He found these models to be accurate predictors. The normality assumption inherent in the multiple discriminant model (but not in a linear probability model) was found to be unrealistic for financial ratios (4).

SELECTING THE SAMPLE

Two samples were selected for this study. The first sample included 49 cooperatives in Iowa and the second 50 cooperatives in Kansas. Data from these States were treated separately because of concern that differences in the type of agriculture being served would result in dif­ferent operating and financial organizations for coopera­tives. The Iowa cooperatives were assumed to be typical of Midwest cooperatives. Selling farm supplies and mar­keting corn and soybeans were principal activities. The Kansas cooperatives also sold farm supplies, and wheat and milo were the principal crops they marketed. They were assumed to be typical of cooperatives serving Plains agriculture. 2

The financial information on farmer cooperatives used in the study came from four annual audits. The audits were conducted for April-March fiscal years 1965/66, 1966/67, 1973/74, and 1974/75.

Before analyzing the audit information, Edmister's approach to averaging data was used (3). Data from the first two time periods 1965/66 and 1966/67 were aver­aged together as well as data from the second two time periods 1973/74 and 1974/75. Averaging was done to minimize the year-to-year fluctuations caused by such things as farmers holding grain in anticipation of higher prices.

IDENTIFYING GROWTH MEASURES

Growth in a business firm is commonly measured in terms of changes in sales, assets, income, or net worth (6). Because this study was concerned with cooperative rather than private business corporations, only changes in sales, assets, and income were considered as measures of growth. Six measures were examined:

I. Percent change in total assets 2. Percent change in total assets less grain inventories 3. Percent change in total assets less investments 4. Percent change in total assets less grain inventories

and investments 5. Percent change in total sales 6. Percent change in operating income The six measures were found to be highly correlated

and thus would be expected to fluctuate similarly. How­ever, the percent change in total assets was selected as the measure of growth for this study because:

1. A review of financial management literature and discussions with officers of financial institutions indicated that changes in total assets was the most acceptable measure of growth. Any sustained increase in a cooperative's business requires more

2 The populations used in this study included cooperatives which were audited by the principal cooperative auditing firm in each State. In Kansas this included virtually all firms. In Iowa 50 percent of cooperatives were audited by the same firm. The population covered in Iowa is, however, typical of all coopera­tives in that State.

30

short-term funding for higher levels of accounts receivable and inventory. Depending upon the capacity at which the firm is operating, facilities may also have to be expanded.

2. The analysis of the statistical characteristics

Table 1-t Ratio results of simple regressions on financial ratios of Kansas and Iowa cooperatives'

t ratio Financial ratio

Kansas I Iowa

Current ratio ...................... 5.24** 1.93 Debt/equity ratio •••••••••••• 0 ••••• -1.51 -2.47* Member investment/total assets ........ 2.79** 1.99 Return on investments ••••••••••••• 0 -0.01 3.81 ** Local return on local assets ........... 4.40** 2.52* Total return on total assets •• 0 •••••••• 3.80** 3.18** Fixed assets/total assets •••••• 0 •••••• -2.70** 0.91 Productivity ratio • 0 •••••••••••••••• 1.36 2.27* Sales/fixed assets ................... 6.60** 1.53 Sales/total assets ••••••• 0 ••••••••••• 1.13 3.22** Local return on fixed assets .......... 8.39** 2.28

1 The dependent variable used in the regression models was percent change in total assets from 1965-66 to 1973-75. The independent variables were calculated from the average of financial information taken from two annual audits between Apr. 1, 1965, and Mar. 31, 1967.

*Significant at the 5-percent level. **Significant at the 1-percent level.

showed percent change in total assets to be the more stable measure. It had the second lowest variance in both States.

The process of identifying financial ratios related to growth involved several steps. First, 18 ratios which covered all of the principal relationships between balance sheet and operating statement items were identi­fied. Simple regression models were estimated using each

of the ratios as independent variables. The dependent variable in the models was the growth measure, percent change in total assets. Those ratios which were signifi­cant at the 5-percent level in at least one of the two States were included in the final group unless they were highly correlated with a previously included variable. The 11 ratios selected for further model development are shown in table 1 and described in table 2.

Table 2-Computation of financial ratios

Ratio

Current ratio ...... .

Debt to equity ..... .

Member investment to total assets ...... .

Return on investments ...... .

Local return on local assets ...... .

Total return on total assets ...... .

Fixed assets to total assets ...... .

Productivity ratio ...

Sales to fixed assets ..

Sales to total assets ..

Local return on fixed assets ...... .

Computation

Total current assets Total current liabilities

Total current liabilities +total long term liabilities

Total member equity 1

Certificates of indebtedness2 +total member equity

Total assets

Dividend income 3

Total investments4

Net local savings5

Total assets· total investments

Total savings Total assets

Net fixed assets Total assets

Rent & lease expense + depreciation expense +interest expense +labor

expense Gross operating income

Total sales Net fixed assets

Total sales Total assets

Net local savings 5

Net fixed assets

1 Total member equity is the sum of stock, retained earnings, and the value of past earnings which have been allocated to member/patron accounts. 2 Certificates of indebtedness are interest bearing notes which have a specified due date. 3 Dividend income represent returns to the local cooperative from investments in regional cooperatives. 4 Total investments include only investments in regional cooperatives. 5 Net local savings are returns earned from the activities of providing products and services to members. Returns on investments are excluded.

31

DEVELOPING A LINEAR PROBABILITY MODEL

Several statistical formulations were considered for this study. A regression model might both explain the growth rates achieved by firms in the two samples and permit the prediction of growth rates for other coopera­tives. The valid application of regression analysis depends variables and functional form for the model. Previous studies do not provide much guidance in the formulation of regression models having firm growth rates as depend­ent variables. They do provide precedents for success or failure formulations. Therefore, for this study, the more limited objective was adopted of developing a model which could distinguish between firms likely to grow rapidly and those likely to have lower growth rates.

Among the formulations compatible with this more modest objective are those of pro bit analysis, discrimi-

nan t analysis, and the linear probability model. Of these, the last two are easiest to implement and, for the problem at hand, are computationally similar (1). How­ever, the usual interpretation of discriminant analysis results requires that the variables-in this case, financial ratios-be normally distributed for each population (high and low growth rate firms). This assumption was not valid for all of the financial ratios used in this study. 3

The linear probability model was adopted because its interpretation is less sensitive to the distributional prop­erties of the fmancial ratios. The fact that predicted values of the dependent variables are conditional proba­bilities also simplifies the interpretation and further sup­ports the choice of the linear probability model.

APPLYING THE LINEAR PROBABILITY MODEL

The most obvious feature distinguishing a linear probability model from an ordinary regression model is the fact that the observed values of the dependent vari­able (y's) are either 1 's orO's. To get the data for this study into this form, each sample cooperative was placed into one of two categories. The cooperatives with higher than average growth rates for their State were classified as high growth, and the dependent variable was assigned the value of 1. The other cooperatives were classified as low growth, and the dependent variable was assigned a value ofO.

After classifying the cooperatives, the data were sub­jected to ordinary least squares (OLS). The y's (condi­tional probabilities) predicted by this model were then used to transform the data so that the classical assump­tion of homoscedasticity could be met. OLS was then applied to the transformed data. 4 The estimated coeffi­cients are presented in table 2. When the estimated coef­ficients are applied to values for financial ratios for a firm, the result is the probability that the firm will expe­rience growth.

McFadden has indicated that in the absence of repli­cation, unmodified residuals from linear probability and related models do not provide a very reliable basis for computing the measures of coefficient reliability and model adequacy usually associated with estimated models (9). It is possible to provide some indication of the extent to which the estimated models for the two States "explain" the high and low growth rates observed

3 Chi-square tests for goodness of fit were used to test the hypotheses of normality for 11 financial ratios. The null hypo­thesis was rejected for one variable.

4 The procedure used is equivalent to the GLS (least squares) method suggested by Goldberger [5]. For both States, some of the initial predicted (y) values fell outside the 0-to-1 range. All of they values were moved proportionately toward a value of .5 to avoid negative estimated error variances.

32

Table 3-Estimated coefficients for linear probability model for identifying growth potential for locally

owned Farmer Cooperatives

Variables

Intercept ................. . Current ratio .............. . Debt/equity ratio ........... . Member investment/total assets . Return on investments ....... . Local return on local assets ... . Total return on total assets ... . Fixed assets/total assets ...... . Productivity ratio .......... . Sales/fixed assets ........... . Sales/total assets ........... . Local return on fixed assets ... .

Kansas

-1.4325 -0.0950 -0.6646 3.4558

-2.9320 1.3145 6.2795 0.0967

-0.4323 -0.0185 -0.0664 0.5623

Iowa

-1.2534 -0.0222 0.0320 0.5508 1.9637 5.6045 1.8862 0.9405 0.1971 0.0807

-0.2038 -2.7073

in the samples and at the same time estimate the appro­priate cutoff percentage for each State.5 Figures I and 2 show the numbers of cooperatives misclassified as high growth and low growth and the total number of mis­classified co-ops as functions of the cutoff percentage.

Two types of errors are possible in the results. Low growth firms may be classified as high growth and high growth firms may be classified as low growth. If, for example, all cooperatives with a probability of .1 0 or higher are classified as high growth, there is a small likeli­hood of classifying a high growth cooperative as a low growth but a high probability of misclassifying a low growth cooperative.

It is up to the decisionmaker to identify the cutoff level which is most appropriate for his situation. For

5 The cutoff percentage is the value between 0 and I which the decisionmaker chooses for purposes of classifying a firm as growth or nongrowth.

FIGURE 1 · '

GROWTH MISCLASSIFICATION OF COOPERATIVES IN IOWA*

NUMBER MISCLASSIFIED

..... ..... Low growth as

.......... high growth

..........

' ' ' ' 15 '

5

' ' ' ' '

CUTOFF PERCENTAGE

*Made by linear probability model using Iowa coefficients.

High growth as low growth

FIGURE 2

GROWTH MISCLASSIFICATION OF COOPERATIVES IN KANSAS*

NUMBER MJSCLASSIFIED

30.-----------------------------------------------------------------~

15

10

5

' ' ' Low growth as ' high growth

' ' ' ' ..... .......... , ' ' ' ' ' ',

CUTOFF PERCENTAGE

*Made by linear probability model using Kansas coefficients.

70

High growth as low growth

80 90 100

33

example, if the user feels it is more costly to misclassify a low growth cooperative than a high growth coopera­tive, the cutoff percentage would be set at a relatively high level. The 50-percent cutoff minimized the number of misclassifications. At this cutoff percentage, 79 per­cent of the sampled Iowa cooperatives and 86 percent of the sampled Kansas cooperatives were classified cor­rectly.

The apparent differences in the estimated coefficients for the two States suggest that the appropriate weights for the fmancial ratios may vary from region to region. The nature of the residuals precluded determining whether or not these differences are significant. Evi­dence from the financial records of the sample coopera­tives in the two States suggests differences in their finan­cial performance and organization. The principal differ­ences were:

I. The Kansas cooperatives were approximately 37 percent larger in size, as measured by total assets, than the Iowa cooperatives.

2. Iowa cooperatives had higher sales volumes than the Kansas cooperatives.

3. Net local savings were over twice as high in Iowa as in Kansas.

4. The Kansas cooperatives were more highly lever­aged than the Iowa cooperatives.

Despite the differences in the cooperatives in the two States, there were some common characteristics associ­ated with growth in both areas. Important similarities which existed prior to the occurrence of high growth were:

1. A low debt-equity ratio (less than .45). The coop-

eratives were not highly leveraged. 2. A higher level of local return on local assets than

existed for the nongrowth group (3.8 percent greater).

3. A higher productivity ratio (greater than 1.8 to I). 4. A higher level of asset turnover. 5. A higher level of returns on assets (at least 8 per­

cent greater than for nongrowth cooperatives).

Summary

The purpose of this study was to develop procedures for identifying the potential for growth in locally owned farmer cooperatives. This was accomplished by first identifying financial ratios associated with growth in this type of business and then developing a model for predic­ting growth.

Simple regression models were used to identify finan­cial ratios associated with growth. Percent change in total assets was selected as the best measure of growth. Eleven financial ratios were identified as being signifi­cantly related to growth in at least one of the two States in the analysis.

With the growth measure, percent change in total assets, and the 11 financial ratios related to growth, a linear probability model was developed. Separate coefficients were developed for both data from Iowa (representative of Midwest agriculture) and for data from Kansas (representative of Plains agriculture). The accuracy of the models in predicting growth was 79 percent for Iowa and 86 percent for Kansas at the 50-percent cutoff point.

LITERATURE CITED

(1)

(2)

(3)

(4)

(5)

34

Altman, Edward I. "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy," The Journal of Finance, Sept. 1968.

Devino, Gary T. "Economies of Size In Farm Supply Indus­tries," Agribusiness Newsletter, Univ. of Missouri, Dept. of Agri. Economics, Nov. I973.

Edmister, Robert 0. "An Empirical Test of Financial Ratio Analysis for Small Business Prediction," Journal of Financial and Quantitative Analysis, Mar. 1972.

Elam, Al R. ;fhe Effect of Lease Data on Predictive Ability. Ph.D. dissertation. Columbia, Mo., Univ. of Missouri, 1973.

Goldberger, ArthurS. Econometric Theory. New York, John Wiley &

(6)

(7)

(8)

(9)

Sons, pp. 244-245. Helfert, Erich A.

Techniques of Financial Analysis. Homewood, ill., Irwin, 4th Edition.

Ladd, George W. "Linear Probability Functions and Discriminant Functions," Econometrics, Oct. 1966, p. 884.

Linke, Charles M. and John A. Hopkins "Financial Aspects of Growth in Agricultural Firms," A New Look At Agricultural Finance Research, Agricultural Finance Program Rept. No. I, Univ. of Ill. at Urbana-Champaign, Dept. of Agri. Economics, 1970.

McFadden, Daniel "Quanta] Choice Analysis: A Survey," Annals of Economic and Social Measurement, Fall I976.

The Effects of Multibank Holding Company Acquisitions on Rural Banking

Warren F. Lee and Alan K. Reichert'

Recent trends toward more concentrated ownership of rural community banks are welcomed by many, based on popular assumptions about economies of size in pro­viding banking services. This article reports the findings of a study in which 43 rural Ohio banks affiliated with multi bank holding companies were compared with simi­lar independent banks in the same communities (14). 2

The underlying hypothesis for this study was that small rural banks that are affiliated with statewide multibank holding companies can capture some of the alleged economies of size inherent in multibank holding com­pany systems and, thereby, offer better and more com­petitively priced services than their independent counter­parts (16).

A bank holding company is a corporation formed for the purpose of owning and managing commercial banks and other firms in certain related fields. Holding com­panies perform no banking functions, and a bank acquired by a holding company retains its own corporate

charter and independent legal status. All holding com­pany acquisitions are subject to the approval of the Board of Governors of the Federal Reserve System. Ap­plications from holding companies to acquire banks are evaluated according to three criteria specified by Con­gress: 1) the possible anticompetitive effects, 2) the convenience and needs of the community to be served, and 3) the financial and managerial resources and future prospects of the holding company and the acquired bank (13).

Ohio provided an excellent environment in which to study the effects of multibank holding companies. In 1960, Ohio had only one active multibank holding com­pany which owned 21 affiliate banks. However, by the end of 1973, there were 12 distinct multibank holding companies which owned 101 of Ohio's 501 banks. Their affiliated banks accounted for 36 percent of total State deposits. 3

REVIEW OF PREVIOUS STUDIES

Several previous studies have examined the structure and performance of commercial banks in rural commu­nities. While the evidence from these studies is not con­clusive, several size-related constraints in banking have been identified (15). Because of equity capital limita­tions, many country banks have low legal lending limits (9, 10). Cost considerations presumably make it difficult for small banks to offer auxiliary financial services such

1 Warren F. Lee is an associate. professor, Ohio State Uni­versity and the Ohio Agricultural Research and Development Center. Alan K. Reichert is an assistant professor, Division of Business and Economics, Indiana University-Purdue University at Fort Wayne. This article summarizes findings of a project funded by the Ohio Agricultural Research and Development Center under Regional Project NC-123.

2 Italicized numbers in parentheses refer to references listed at the end of the report.

as computerized data processing, trust departments, credit cards, and specialized services such as agricultural departments. Maintaining an adequate supply of loana­ble funds is a problem for many rural banks. A Federal Reserve Board study on this problem concluded that improved access to Federal Reserve discount credit, more effective marketing of negotiable instruments and finance acceptances, and revisions of correspondent banking practices are needed (2, pp. 1-1 0). Some small banks have to adopt conservative asset management policies (such as a greater ratio of liquid reserves to total assets) because they cannot spread their risks either geo-

3 The trend to holding company domination of banking has been similar fo'r the entire United States. At the end of 1973, multibank holding companies owned about 1,726 of the Na­tion's 14,170 commercial banks. These affiliates accounted for slightly more than one-third of all commercial bank deposits.

35

graphically or among different economic sectors (1). These size-related diseconomies have, in part, been

responsible for the general trend to fewer and larger banks over time. Although most States prohibit or restrict branch banking, there have been significant changes in the structure of the banking industry during the last 15 years. Where State laws permit, there have been many bank consolidations through mergers (8). Perhaps the most significant structural change has been the large number of acquisitions by multi bank holding companies following the 1970 amendments to the Fed­eral Bank Holding Company Act (5).

Several studies have examined relationships between bank structure and performance. The Federal Reserve Bank of Chicago recently published a review of the key findings in the literature on multibank holding compa­nies (6). Various aspects of bank performance are con­sidered, such as the availability of banking services, market concentration and competition, product pricing, bank operating efficiency and profitability, the alloca­tion of bank funds, bank soundness, and regulatory benefits. The fmdings generally indicate that multibank holding companies offer a somewhat broader range of banking services.

Although the holding company movement may have increased the level of concentration at the State and national levels, there has been no significant impact on local bank market concentration.

The results of these studies also indicate that hold­ing companies charge slightly lower rates of interest on loans, impose higher service charges, and pay somewhat higher rates on time and savings deposits. Furthermore, the evidence suggests that some diseconomies may be associated with a given level membership as average operating expenses associated with a given level of out­put appears to be significantly higher for affiliated banks. These higher expenses are generally attributed to higher interest expense on time and savings deposits and to "other" operating expenses.

The combination of lower prices and higher costs have combined to reduce the ratio of net income to total assets for most affiliated banks. The ultimate im­pact on return on net worth is moderated somewhat in that affiliated banks characteristically are less well capi­talized than their independent counterparts. The higher loan-to-deposit ratio typical of multi bank holding com­panies suggests somewhat greater efficiency in the inter­mediation process as affiliate banks shift from low risk, low return assets such as U.S. Treasury securities-to higher risk, higher yielding assets such as loans and State

36

and local securities. Finally there appears to be no evidence to support

the claim that holding companies attempt to redistribute credit across markets for one reason or another. Overall, the Chicago study concludes that multibank holding companies have had a slightly favorable impact upon the banking system (11, 6 p. 14).

Gady and Carter analyzed performance data for a number of rural Ohio banks which had experienced either a merger or holding company acquisition during the 1960's (6, 2, pp. 130-133). They found that both bank mergers and acquisitions lead to a more aggressive over­all lending position, although farm lending activity sub­stantially declined. A shift away from investment in U.S. Government securities to local security issues was also noted, but no major reallocation of funds was observed.

In another study of Ohio bank structure, Ware con­trasted the performance of a number of affJliated banks with a group of comparable independent banks (18, 19). The results indicated a significant shift from mortgage lending to business and consumer loans on the part of the afftliated banks. While there appeared to be little difference in average prices of bank services, net profita­bility was essentially unaffected by acquisition as higher operating costs substantially offset increased operating revenues.

Hayenga and Brake, in an analysis of rural bank merger activity in Michigan, found that merger activity generally served to improve the quality of bank services in most areas (8). Their findings were somewhat mixed regarding lending behavior, as increased real estate lending was coupled with a slightly reduced level of farm lending following the merger.

Snider's study of rural bank mergers in Virginia indi­cates some contrasting results (2, pp. 112-114; 17). Snider systematically analyzed paired merged and inde­pendent banks and found that the merged banks tended to place greater emphasis on consumer lending and ex­perienced faster total deposit growth than independent banks. It was also noted that while agricultural lending was, in general, declining throughout the period of study, agricultural lending declined less for the group of merged banks. These and other fmdings led Snider to conclude that mergers have resulted in a general improvement in rural banking services in Virginia. Sullivan's analysis of holding companies and farm lending in Florida con­cluded that farm lending tended to decrease soon after banks became afftliated with a holding company (2, pp. 125-129). .

METHODOLOGY

Sample Selection for Subject Study

The population for this study was defined as all rural-based affiliates of multibank holding companies that owned five or more affiliate banks each at the end of 1973. Seven of Ohio's 12 multibank holding companies met this criterion and six of these organizations agreed to cooperate in the study. These six bank groups accounted for 86 affiliates, or about one-sixth of all Ohio banks, and $7 billion in deposits, or about one-quarter of all bank deposits in Ohio as of yearend 1973.

In an attempt to identify variations in rural bank per­formance, only those affiliate banks located in moderate­ly small communities in predominantly rural areas were selected for study. Banks located in, or within 15 miles of, communities with populations over 25,000 were excluded. This procedure was used to define reasonably isolated banking markets with minimum influences associated with metropolitan bank markets. Forty-five of the 93 afftliate banks fulftlled the location criterion.

A group of independent banks was selected for use as a standard against which the performance of the holding company affiliates could be measured. Each affiliate bank was paired with one independent bank, or a composite of two or more, located within a 35-mile radius of the affiliate's main office. In addition to the location criterion, each eligible independent had to be reasonably comparable to the affiliate bank in terms of four financial variables observed I year prior to affilia­tion. These four financial performance variables were total deposits, rate of growth in total deposits over the 5 years preceding affiliation, ratio of time and savings deposits to total deposits, and the loan-to-deposit ratio.

All independent banks located within each affiliate's home county and all contiguous non-SMSA (Standard Metropolitan Statistical Area) counties were examined for comparability. Independent banks whose four per­formance variables were within plus or minus 20 per­cent of the affiliate's performance prior to its affiliation were selected.4 When two or more independent banks met the comparability test, they were averaged together to form a single composite independent bank.

Of the 45 affiliate banks initially selected for study, two had to be deleted because no reasonably compara­ble independent banks were identified. The remaining 43 affiliates were paired with a total of 101 independent banks. 5 Pair~d comparison t-tests on 33 financial varia­bles from the sample banks' Reports of Condition con­firmed that, in addition to the four performance variables

4 For example, if an affiliate bank had total deposits of $25 million the year prior to affiliation, all nearby independent banks with total deposits between $20 million and $30 million in that same year were judged to be reasonably comparable in terms of this variable.

used, the two groups of banks were quite similar in most other respects prior to afflliation. Thus, any significant differences in the 1972-73 post affiliation period could, with substantial justification, be attributed mainly to differences in ownership and management resulting from holding company afflliation.

Performance Criteria and Hypotheses

The Federal Reserve Board is instructed to approve a holding company's application to acquire a bank if the acquisition has no anticompetitive effects or if the anti­competitive effects are clearly outweighed by the promise of enhanced banking services for the community. In either case the financial condition of the bank and the holding company are carefully considered. On the basis of these criteria alone, one might expect holding com­pany afflliates to become larger, more profitable, and generally more efficient than their independent counter­parts. In addition, afflliate banks might be expected to offer more competitive interest rates on both loans and deposits and a greater variety of banking services.

Consequently, it was hypothesized that the affiliate banks would be larger in terms of total deposits and more effective in terms of assets and liabilities manage­ment. It was further expected that these superior man­agement practices would be reflected in higher profita­bility for the affiliate banks.

Sources of Data

Three sources of data were used. In summer 1974, personal interviews were conducted with the senior management personnel of the six holding companies that owned the 43 affiliate banks in the sample. They were asked to provide information on acquisition objectives, management and marketing policies, and the types of services provided to their afflliate banks.

The sample banks' Reports of Condition for 1960 through yearend 1973 and their Reports of Income and Dividends for 1972 and 1973 provided a wealth of fman­cial data ( 4). These data were supplemented with addi­tional qualitative and quantitative information obtained from a mail-in survey of the sample banks conducted in early 1975. Completed questionnaires were received from 27 of the 43 affiliate banks and 54 of the 101 independent banks, for an overall response rate of 56 percent.

'In three cases, only one comparable independent bank was identified while one affiliate had 10 comparable independents. On average, 3.3 independent banks were associated with each affiliate.

37

RESULTS

Bank Profitability and Efficiency

The holding company representatives interviewed unanimously expressed an overall objective of increas­ing the level of expected after-tax earnings per share on the holding company stock. Each affiliate bank was expected to contribute proportionately to the profita­bility of the system after an initial adjustment period. Furthermore, there appeared to be a belief that the best route to achieving higher longrun holding company profits was to acquire more banks in an effort to in­crease their share of the State's total volume of deposits and loans.

The six holding companies surveyed for this study had tried to make each affiliate a profitable member of the system as quickly as feasible. Each affiliate bank was usually required to submit a detailed statement of its fm~ncial condition to the holding company on a regular basis. The holding companies used this information to closely monitor the liquidity positions of their affiliates. In most cases, the lead bank became the primary corre­spondent for all smaller banks in the holding company. Compensating balances were centralized within the organization and the use of "outside" correspondents was discouraged. Banks with surplus liquidity were urged to enter loan participation agreements with other banks in the system. One of the holding companies in the sample had developed a formal system for coordinat­ing loan participation agreements among its affiliates. A majority of the holding companies indicated a desire to make their affiliate banks' pricing decisions more respon­sive to regional money market conditions. In addition, th~ management of the affiliate banks' securities port­folios was usually centralized with the holding company or the lead bank.

Holding companies provide a variety of supporting services to their affiliate banks. In most holding com­panies studied, data processing services were being standardized for all affiliate banks. Although no wide­spread policy of staffing affiliate banks with holding company personnel was evident, greater employee mobility among the banks in each holding company was being facilitated by systemwide employee benefit and retirement plans. The six holding companies surveyed were also coordinating marketing efforts such as cus­tomer surveys and advertising layouts. All affiliates had been encouraged to adopt the same credit cards, 24-hour automated teller systems, and packaged service plans as the lead bank. Services from the lead banks' trust depart­ments and international departments were also generally made available to all banks in the system.

Quantitative Differences in Financial Performances

The financial performance of the 43 matched bank pairs was measured for the 2-year period, 1972· 73. Seventeen variables were chosen to measure quantitative

38

differences in bank size, asset management practices, liabilities management practices, and profitability. Paired comparison t-tests were used to detect statistically signifi­cant differences between the mean values of each variable (table 1).

The results indicate that both groups of banks were virtually identical in terms of size as measured by total deposits. Both groups also had approximately the same loan-to-deposit ratios;however, compared with the inde­pendent banks, the holding company affiliates were in­vesting a significantly higher proportion of their loan funds in consumer loans and significantly lower propor­tions in residential mortgages and farm loans. Commer· cialloans accounted for approximately equal proportions of total loans for both bank groups. These differences in loan portfolio composition resulted in significantly dif· ferent gross yields on loans-8.4 percent for the affiliates compared with 7.8 percent for the independents.

The differences in loan portfolio composition proba­bly reflected the response of the profit-oriented affiliates to the Ohio usury law which, in 1972-73, limited the contractual rate of interest on most loans to individuals to a maximum of 8 percent. Usury ceilings can be cir­cumvented on most types of consumer installment loans by using addon or discount methods to compute finance charges (13). Opportunities for increasing effective yields above the 8-percent ceiling are much more limited for long-term mortgage loans. The usury law along with competition from production credit associations and Federal land banks have made farm loans relatively un­attractive for banks in Ohio. . Des~it~ the services available to affiliates for manag­mg then mvestment portfolios, the independent banks earned significantly higher average yields on their Gov­ernment securities in 1972-73 (5.2 percent versus 4.8 percent for the affiliates). Government securities accounted for a significantly higher proportion of total assets for the affiliates, and U.S. Government securities constituted about 65 percent of total securities for the affiliates versus 55 percent for the independents. This finding was somewhat surprising because State and local issues generally offer higher after-tax yields. Further analysis revealed that this result could be attributed to ~he investment behavior of the largest holding company m the sample. All other holding companies exhibited the predicted investment behavior of preferring State and municipal securities over U.S. Government issues.

Significant differences in liabilities management practices were also noted (table 1). The affJ.liate banks were operating with a slightly higher degree of financial leverage-a total capital to total deposit ratio of 8 per­cent versus 8.6 percent for the independent banks. There is also some evidence that the affiliate banks were mak­ing an effort to attract deposits as evidenced by the 0.3-percent higher average rate they were paying on time and savings deposits. Nevertheless, individual, personal,

Table f-Selected financiai comparisons of 43 pairs of holding company affiliates and independent banks in nonmetropolitan Ohio counties, 1972-73

Variable description 1

Mean affiliate bank value

Mean independent bank value Significance I evel 2

Total deposits ($1 ,000) ...................... . 23,593 22,481 n.s.

Assets management variables Total loans 7 total deposits ................. . Real estate loans 7 total loans ............... . Total farm loans 7 total loans ................. . Commercial loans.;- total loans ............... . Consumer loans.;- total loans ................ .

Average annual return on loans ............. .

Total securities 7 total assets ................ . U.S. Government 7 total securities ............ .

Average annual return on securities .......... .

Liabilities management variables Total capital .;- total deposits ................ . Demand deposits I.P.C . .;-total deposits ........ . Time and savings deposits I.P.C . .;-total deposits .. Government deposits.;- total deposits .......... .

Average annual rate of interest paid on time and savings deposits ....................... .

Profitabi I ity variables Total operating income.;- total earning assets .... . Net operating earnings.;- total capital .......... .

.564

.385

.107

.163

.389

.084

.357

.652

.048

.080

.262

.590 .139

.053

.078

.121

.583 n.s.

.434 5%

.141 1%

.142 n.s.

.341 5%

.078 1%

.319 10%

.554 1%

.052 5%

.086 5%

.289 5%

.627 5% .075 1%

.050 5%

.078 n.s.

.124 n.s.

2 1 Financial flow ~ariables were averaged for calendar years 1972 and 1973. Financial stocks were observed as of yearend 1972.

Denotes whether d1fferences between means for paired banks were not significant (n.s.), or significant at the 1- 5- or 1 O-percent levels. ' '

and corporate time and savings deposits represented a significantly higher proportion of total deposits for the independent banks.

The most notable difference in sources of funds was observed in the ratio of government deposits to total deposits. Government deposits accounted for an average of 13.9 percent of the affiliates' deposits, compared with only 7.5 percent for the independents. Although govern­ment deposits are not broken down by level of govern­ment, it is likely that in most rural communities, these deposits would be from State and local government units. Public deposits tend to be an attractive source of funds since they are usually fairly large, with predictable in­flows and outflows. Government deposits represent a low cost source of funds given current regulations against interest payments on most public deposits.

Despite these observed differences in assets and lia­bilities management practices, there were no discernable differences in the profitability of the two groups of banks in 1972-73. Both groups earned nearly 8 percent on total assets and a 12-percent rate of return on their equity capita1.6

6 These rates of return were computed by expressing the aver­age ~nnual earnings in 1972-73 as a percentage of yearend 1972 earnmg assets and total capital.

Qualitative Differences in Banking Services

The mail-in survey data provided additional informa­tion on the two major banking services-deposits and loans-as well as descriptive information on auxiliary banking services.

As the data in table 1 indicate, the affiliates were paying an average of 5.3 percent on all interest bearing deposits compared with the 5.0-percent average rate paid by the independents. A 0.3-percent interest rate differen­tial may not appear to be very important to an individual depositor; however, the survey data revealed that effec­tive yields on time and savings accounts in the respond­ing affiliate banks were further enhanced by more fre­quent compounding and crediting of interest earnings.

At the same time, the survey data revealed that the effective rates of interest on all types of personal and business loans from affJ.liate banks were 0.3 to 0.5 per­centage points above the independent banks' rates on s~rnilar loans. These higher contractual rates were par­tially offset by the more liberal lending policies of the afflliates; in general, they offered lower minimum down­payment requirements and somewhat longer loan repay­ment periods. It was also observed that the affiliates tend to follow more standardized and more formal loan evaluation procedures.

39

Given the high degree of regulatory and legal restric­tions on price competition in banking, banks typically engage in various forms of non price competition in an effort to differentiate their services. Large, attractive offices, drive-in windows, 24-hour automated tellers, credit cards, and packaged service plans are common.

Because of their close ties with their parent corpora­tions and lead banks, holding company affiliates should be in a position to offer a wider range of these auxiliary services. Surprisingly, the survey revealed that a higher proportion of the responding independent banks, either on their own or with the assistance of a city correspond­ent, were offering credit cards, 24-hour automated tellers, bookkeeping, financial and tax advice, and billing and inventory accounting.

The most notable difference was in the area of farm management services. Nearly 41 percent of the respond­ing independent banks were offering some type of spe­cialized agricultural lending and counseling services, compared with only 7 percent of the responding afflli­ates. Trust management was the only major service offered with greater frequency by the afflliate banks, as all responding affiliates indicated that trust services

were offered through their holding company or corre­spondent banks.

The questionnaire results indicate that the holding companies were attempting to facilitate the reallocation of loanable funds among their member banks. The affili­ate banks reported purchasing a greater number of larger loan participations than did the independent banks. At the same time, the afflliate banks were more effective in initiating participation arrangements within the hold­ing company system than those independents seeking similar services from their correspondent banks.

The affiliate banks reported purchasing an average of 7.0 loan participations during 1974 representing an aver­age total investment of $693,000 per bank. The inde­pendent banks reported participating in an average of 3.4 loans during the same period with an average total investment of $329,000 per bank. For participations initiated by the sample banks, the affiliates reported an average of 4.6 participations each with an average total value of $964,000, compared with 3.2 participations averaging $587,000 per bank for the responding inde­pendents.

CONCLUSIONS

Given the statutory standards applied by the Board of Governors when approving bank acquisitions by multibanks holding companies, it was hypothesized that affiliate banks in rural communities would be more profitable than comparable independent banks. It was also expected that the affiliates would be in a position to offer more auxiliary banking services.

Although afflliate banks legally retain an independ­ent corporate status, it is apparent that they are treated by holding company management as part of an inte­grated system. Centralized management was evident in policies such as regular financial reporting, internalized compensating balances, coordinated loan participations, standardized marketing and advertising programs, and centralized management of government securities port­folios.

Holding company involvement in the management of afftliate banks was reflected in their asset and liabilities management practices. Compared with their independ­ent counterparts, the affiliates clearly demonstrated a preference for higher yielding consumer installment loans over residential mortgages and farm loans. While not reflected in the aggregate figures due to atypical behavidr on the part of the largest organization in the sample, the holding companies generally reduced their holdings of cash and U.S. securities in favor of tax­exempt municipal issues. The affiliates were paying slightly higher effective rates of interest on interest bearing deposits than independent banks, and govern­ment deposits made up a much larger proportion of the affiliates' total deposits.

40

Despite these differences in management, the hypoth­eses regarding profitability and expanded bank services were generally not supported. The two groups of banks earned similar rates of return on both earning assets and equity capital in 1972-73. Furthermore, the bank survey results indicate that the independent banks were offering at least as complete a range of auxiliary services as were the affiliates and, in certain areas such as farm manage­ment counseling, the independents were clearly superior.

There are two plausible explanations for these results. First, the holding company movement is relatively new. Most of the 43 affiliate banks studied were acquired after 1969; hence, there may not have been sufficient time for the changes in management to be reflected in significantly higher profits by 1972-73. Second, since rural bank markets tend to be oligopolistic, independent banks may be forced to retaliate with their own set of auxiliary services and increased advertising when a near­by competitor is acquired by a holding company. Thus, although a holding company affiliate may be the first to offer a new service in a community, one would not expect to observe significant differences in bank services once the independent banks have had time to respond. Since many bank services are too costly for a small bank to offer on its own, a holding company acquisition in a small community may force nearby independent banks to develop closer working relationships with their city correspondents or to join bank consortiums in order to remain competitive.

These findings have several implications for owners, managers, and customers of banks in rural communities.

Owners and managers clearly relinquish control of their bank when they become affJliated with a holding com­pany. In many cases, affiliation may be the only method of resolving serious financial or management problems in a small bank. However, the results of this study suggest that independent banks in rural Ohio. can compete effec­tively with holding company affiliates in their market areas. Thus, other solutions such as improved corre­spondent relationships should probably be investigated before reaching a decision to affiliate with a holding company.

Holding companies have mixed impacts on bank customers. Depositors clearly benefit from the higher interest rates that result from holding company compe­tition. Borrowers may be better or worse off depending on the type of credit they are seeking. Farmers and resi­dential mortgage borrowers are more likely to be better served by an independent bank because, when interest rates are high, the profit-oriented afflliates tend to allo­cate lower proportions of their loanable funds to those types of loans covered by State usury laws. Borrowers seeking consumer installment credit will generally

receive more favorable terms from affiliates, although the effective rate of interest will be slightly higher. All borrowers can anticipate a more formal, and presuma­bly more objective, evaluation of their loan applications from affiliate banks. Clearly, there are many borrowers who prefer the less formal or personal approach.

As with previous studies on bank structure, the results of this study are somewhat mixed, with both advantages and disadvantages associated with holding ownership. An in-depth study of the bank service needs of customers in rural communities would be a useful followup. For instance, how have local bank customers responded to the consumer orientation of the affJliate banks? Have large agricultural and commercial borrowers found holding company afflliates to be more capable of handling their credit needs? What impacts have the more formalized operating procedures of affiliate banks had on customer attitudes and loyalty? Final answers to the multibank holding company question will ultimately depend upon a careful analysis of these and similar questions.

LITERATURE CITED

(1) Barry, Peter J., Gregory J. Greathouse, and Kamol Boondiskulchok

Country Bank Management of Yield, Risk and Liquidity of Agricultural Loans. lnf. Rpt. 744, Texas A & M Univ., 1974.

(2) Board of Governors of the Federal Reserve System Improved Fund A vail ability at Rural Banks. Re­port and Study Papers of the Committee on Rural Banking Problems, June 1975.

(3)

(4)

(5)

(6)

(7)

(8)

Regulation Y, Sec. 3(c), Bank Holding Com­pany Act of 1956. 1956.

Reports of Condition, 1960-1973 and Reports of Income and Dividends, 1972, 1973.

Boczar, Gregory E. The Growth of Multibank Holding Companies: 1956-73. Staff Paper 85, Bd. of Governors of Fed. Res. System, 1975.

Drum, DaleS. "MBHC's: Evidence After Two Decades of Regulation," Business Conditions, Fed. Res. Bank of Chicago, Dec. 1976.

Gady, Richard L. "Performance of Rural Banks and Changes in Bank Structure in Ohio," Economic Review, Fed. Res. BaD.k of Cleveland, Nov.-Dec. 1971.

Hayenga, Wayne A., and J. R. Brake Some Effects of Rural Bank Mergers on Finan­cial Services Available to Rural Michigan Resi­dents. Res. Rpt. 243, Michigan State Univ., Agri. Expt. Sta., Mar. 1974.

(9) Hopkin, J. A., and T. E. Frey Problems Faced by Commercial Banks of Illi­nois in Meeting the Financing Requirements of a Dynamic Agriculture. AERR 99, Univ. of Illinois, Dept. of Agri. Econ., 1969.

(10) Meier, H. A., and D. E. Hahn

(I I)

{12)

(13)

(14)

(15)

"Farm Lending Practices of Ohio's Commercial Banks," Ohio Report 58(5), Ohio Agri. Res. and Development Center, Sept.-Oct. 1973, pp. 104-108.

Melichar, Emanuel "Toward a Seasonal Borrowing Privilege: A Study of Intrayear Fund Flows at Commercial Banks," Reappraisal of the Federal Discount Mechanism, Vol. 2, Bd. of Governors of Fed. Res. System, 1971, pp. 93-106.

Mote, Larry R. 'The Perennial Issue: Branch Banking," Busi­ness Conditions, Fed. Res. Bank of Chicago, Feb. 1974, pp. 3-23.

Nelson, Aaron G., Warren F. Lee, and William G. Murray

(Agricultural Finance, 6th ed., Ames, Iowa). Iowa State Univ. Press, 1973.

Reichert, Alan K. The Effects of Bank Holding Company Growth on Ohio's Rural Capital Markets. Unpublished Ph.D. dissertation, Ohio State Univ., 1975.

Shane, Mathew Minnesota's Bank Structure. Staff Paper P73-19, Univ. of Minnesota, (Dept. of Agri. and Applied Econ.) July 1>973.

41

(16) Schweitzer, Stuart A. "Economies of Scale and Holding Company Affiliation in Banking," Southern Economic Journal, XXXIX, Oct. 1972.

(17) Snider, Thomas E.

42

"The Effect of Merger on the Lending Behavior of Rural Banks in Virginia," Journal of Bank Research, Spring 1973.

(18) Ware, Robert F.

(19)

"Characteristics of Banks Acquired by Multi­ple Bank Holding Companies," Economic Re­view, Fed. Res. Bank of Cleveland, Aug. 1971.

"Performance of Banks Acquired by Multibank Holding Companies in Ohio," Economic Review, Fed. Res. Bank of Cleveland, Mar.-Apr. 1973.

Real Estate Seller Financing and Tax Management: A Profitability Analysis

Peter J. Barry and Donald R. Levi '

Data published by the Department of Agriculture indicate that the individuals who sell their farms on contract, or by personal mortgage provide the largest amount of farm real estate debt in the United States. In the year ending March I, 1976, financing by the seller was estimated to comprise about 44 percent of all new credit extended for farm real estate transfers. About three-fourths of the seller financing occurred with seller contracts, while about one-fourth occurred with seller mortgages. Moreover, on January I, 1976, individuals and other noninstitutional lenders were estimated to hold about $18.7 billion of outstanding farm real estate debt-about 37 percent of the total. These proportions appear roughly consistent with previous market shares extending back to the early 1950's.

Clearly, seller financing is a significant and apparently stable source of debt for transferring farm real estate. In addition, the direct negotiation between seller and buyer that bypasses specialized lending institutions is a unique form of financial intermediation in the United States.

Despite its widespread use, the motivations under­lying seller financing are not well understood. For retiring farmers, seller financing is believed to provide a steady and easily manageable flow of ret urns from an agricultural investment when payments of principal and interest are made. Favorable financing terms may also broaden the demand for the seller's farm, especially dur­ing tight money periods, and may tend to enhance the

sale. However, in recent years, the most prominent rea­son for seller-financing has likely been the opportunity to convert ordinary income capital gains, thereby reduc­ing income tax obligations that are associated with the sale by deferring part of the capital gains tax obligation to future years.

While there is abundant literature citing general fea­tures of seller financing, there is relatively little empirical study of its actual use and market effects. Much of the literature tends to emphasize the tax savings for the seller rather than focusing on his after-tax wealth. Studies taking this approach include those by Elefson and Raup, Gale, Hill and Harris. Even major texts on agricultural finance (Hopkin, Barry and Baker; Nelson, Lee and Murray) and agricultural law (Levi) tend to highlight the tax savings. Boehlje's study provides only limited treatment on the opportunity for reinvestment of sale proceeds, although the inflation effects of the in­stallment sale are emphasized. Reinsel focuses primarily on tax savings by studying effects of trade-offs between the sale price and the installment rate of interest.

The main purpose here is to suggest a method of analyzing the profitability of various seller fmancing arrangements, arrangements that include the tax savings generated by installment sales and the returns earned by reinvesting the proceeds of the real estate sales. Profita­bility responses to variations in tax brackets, inflation, and income averaging as a tax alternative are also con­sidered.

CHARACTERISTICS OF SELLER FINANCING

Table I shows the latest published data (January !­June 30, 1971) on selected characteristics of farm real estate loans from individuals and other lenders (USDA, 1973). Data indicate that interest rates and loan maturi­ties tend to be less on loans from individuals. With downpayments relatively low and arrangements general­ly having maturities shorter than 20 years, often a large

I Associate Prol'cssor and Professor or Agricultural Economics, respectively, Texas A&M University, College Station.

final or balloon payment is required at the completion of the repayment period. However, these terms do vary greatly, especially for transfers between father and son or other relatives.

Land contracts, mortgages, and deeds of trust can be used in the seller-financed arrangement. A land contract is an agreement to transfer-permanently -real estate control to the buyer, while title remains with the seller until repayment conditions of the contract are met. With a mortgage and deed of trust, title is transferred

43

Table 1-U.S. farm mortagages recorded: Average interest rates, loan length, and size of loan by lender group, January 1 ·June 30, 1971

Life Item All lenders Federal Insurance

Land Bank Co.

Interest rate, percent ...... 7.45 7.76 8.37 Length of loan. years ...... 15.9 29.1 20.7 Size of loan ............. $26,800 $32,670 $52,530

Source: USDA, 1973.

to the buyer at the time of sale and a first lien is exe­cuted in favor of the seller-lender. In the case of default, mortgages are foreclosed through court action in a rela­tively slow, costly process. In contrast to a mortgage, a deed of trust gives the trustee the power to foreclose and sell the property without judicial action-quickly and inexpensively. These legalities and the extent of use of contracts, mortgages, and deeds of trust vary from State to State.

In installment ~ales, tax considerations are attributed to the rather large capital gains incurred in the sales of most farms. Capital gains are the difference between the sale price and the seller's basis in the property. The basis is the price the seller paid for the farm, increased by the cost of capital improvements to the land, and decreased by depreciation claimed or allowable on all depreciable items legally considered to be a part of the land. Techni­cally separate, capital accounts should be kept for land and each depreciable item reflecting adjusted basis. 2

Capital gains on real estate held 9 months or less are considered short-term gains and are taxed as ordinary income. Long-term capital gains occur on real estate held longer than 9 months. 3 In determining his tax obliga­tion, the noncorporated seller can choose to (1) pay tax on one-half of the long-term capital gain at ordinary rates or (2) pay a 25-percent tax on the first $50,000 of a long-term gain $25,000 for single or separate returns) and 35 percent on additional long-term gain. In addition, the noncorporate seller with capital gains is also subject to a minimum tax. The minimum tax is cal­culated as 15 percent of the difference between one­half of the long-term capital gain and the larger of $10,000 or one-half of the taxpayers regular tax liability for the year.

Sellers who finance their sales on an installment basis using a contract, deed of trust, or mortgage have the advantage of reducing the current tax obligation and deferring part of the obligation to future years. This advantage occurs because the Internal Revenue Code and income tax regulations permit capital gains from certain seller-financed sales of an asset (e.g., real estate) to be

2 Separate accounts facilitate computation of depreciation and investment credit which are not treated in this analysis.

3 This holding period is extended to I year for assets disposed of in I 978 and thereafter.

44

Banks Farmers Production and Home Ad· · Credit As- Savings Individuals

Trust Co. ministration sociation and loans

7.80 5.35 7.67 7.89 6.50 7.3 33.1 2.9 16.9 11.4

$19,030 $22,300 $34,170 $20,140 $27,190

spread over the years of repayment if the seller receives 30 percent or less of the sale proceeds in the year of sale, provided that at least one payment occurs in each of 2 years and the seller is not legally classified as a real estate dealer or subdivider (see appendix).

To illustrate the tax effects, consider the sale of a 100-acre tract that has increased in value from its pur­chase price of $50,000 in 1960 to $250,000 now. Let all the $200,000 be long-term capital gain and assume for simplicity of calculation that the seller has no other tax­able income. If he receives a cash payment for the total amount, his regular tax obligation in the year of sale is $45,180-found by taxing one-half of the capital gain at ordinary income tax rates for a taxpayer filing a joint return. In addition, his minimum tax is $11 ,612-found by taxing the difference between one-half the long-term capital gain ($200,000) and one-half of the tax liability of $45,180 at IS percent. Hence, his total tax obliga­tion is $56,792.

Under the IRS installment sale provisions, the capital gain of $200,000 is taxable as received over the life of the financing arrangement. The capital gain that is to be reported each year under the installment method is equal to the contract price times the gross profit per­centage. The contract price equals the sales price minus any mortgaged indebtedness on the property that is assumed by the buyer. If there is no existing mortgage, the contract price equals the sales price.

The gross profit percentage is found by dividing the difference between the sales price and the adjusted basis by the contract price. In. this example, assume that there is no existing mortgage on the land being sold. The gross profit percentage therefore is 80 percent-the difference between the sales price ($250,000) and adjusted basis ($50,000) divided by the contract price ($250,000). Consequently, the down payment and each annual install­ment is assumed to be comprised of 80 percent capital gains income.

Suppose that the seller requires a 28-percent down­payment of $70,000, with the balance payable in 10 annual installments of $18,000 plus interest charged at 7 percent on the remaining loan balance. Of the $70,000 downpayment, 80 percent or $56,000 is considered as taxable, long-term capital gains; similarly, $14,400 (80 percent of $18,000) of each annual installment is con­sidered as taxable, long-term capital gains. If one-half of the capital gain is taxed at ordinary income rates in each

year (ignoring for now the interest income), and a mini­mum tax is paid on the capital gains in the downpay­ment, the total tax on capital gains over 10 years is

$21 ,840-considerably less than the $56,792 tax obliga­tion for the cash sale. This total tax of $21,840 is not discounted for time.

PROFIT ABILITY ANALYSIS

Clearly, the installment sale yields a lower total tax obligation than the cash sale. However, it seems reasona­ble to assume that most sellers are motivated by the prospects of after-tax wealth rather than tax minimiza­tion. Hence, there is need to compare the after-tax profi­tability of installment and cash sales, with explicit recog­nition that deferring the receipt of principal and interest in installment sales also defers the receipt of income that could be earned from reinvesting the sale proceeds in other profitable investments.

Either the net present value (NPV) or internal-rate-of­return (IRR) methods can be used to compare the profi­tability of installment and cash sales. The two methods are closely linked and both account for the time value of money. In the net present value method, a specific dis­count rate is selected to derive the present value of the after-tax cash flows associated with the installment sale (PVis). The discount rate reflects the seller's after-tax opportunity cost or after-tax required-rate-of-return on reinvestment of the proceeds of the installment sale. The net present value of the installment sale (NPVis) is then defined as the difference between the present value of the installment sale (PVis) and the present value of the cash sale (PV cs).

NPVis = PVis- PV cs

The best choice is based on the following decision rules: if (NPVis) is positive, accept the installment sale; if (NPVis) is zero, be indifferent; if (NPVis) is negative, accept the cash sale.

The IRR approach seeks to find that discount rate which equates the net present value of the installment sale to zero. That is, find the discount rate such that:

0 = PVis- PVcs

The better way is then determined by comparing the internal-rate-of-return (IRR) to the seller's required-rate­of·return (RRR) and is expressed by the following rules: if IRR exceeds RRR, accept the installment sale; if IRR equals RRR, be indifferent; if IRR is less than RRR, accept the cash sale. Generally, the net present value and internal-rate-of-return methods lead to similar results, although the NPV is considered superior primar­ily because it assumes that the future flow of payments is reinvested to earn returns at the investor's opportunity cost rate. In contrast, the IRR assumes that the future flow of payments is reinvested to earn returns at the lRR rate. It is generally more reasonable to assume that the seller's reinvestment rate is the same for all alterna­tives, as is the case with the NPV method.

The following analysis uses both the net present value and the internal-rate-of-return methods to evaluate the profitability of installment sales. The first step is to formulate a general cash flow model for deriving the net present value of the installment rate. The following nota­tions are introduced:

P0 the sales price of the land B the sellers basis in the land Pn annual principal payments on the installment

sale In annual interest payments on the installment

sale d the percent downpayment

the average tax rate on ordinary income attributed to the land sale

N = the length of installment period i = the discount rate with i = IRR for PV cs = PVis En $10,000 or one half the regular tax liability,

whichever is larger (Minimum Tax) = (.15)[(~) (P 0 - B)- En]

Then, the models for (PV cs) and (PVis) are expressed as follows.

PVcs = P0 - (P0 - B)(~) (t)- (MINT AX) (1)

The present value of the cash sale (PV cs) is simply the value of the sale minus the tax obligation on capital gains and the minimum tax. Hence

PVcs = 250,000-45,180- 11,612 = 193,208

This figure is the present value that is available for other investments. For simplicity, it is assumed that the tax payments occur at the time of sale; hence, no time discounting is needed.

The (PVjs) model is expressed as:

PVis = [dP0 - (dP0 ) (Pop: B) (~) (t)- (MINTAX0 )]

+ n~1 l [Pn +In]

_ [t] ['• + (") (Pnl(P0p~ 8)] - (MINT AXn) I (1 + i)-n

45

This model reflects the present value of after-tax cash flows associated with the installment sale. The first term is the after-tax cash generated by the downpayment. The second term reflects the summation of the discounted after-tax cash flows generated by the installment pay­ments of principal and interest. Principal and interest payments in each year are reduced by the level of the seller's tax obligations on interest income and one-half of the proportion of each principal payment that is con­sidered to be long-term capital gain plus the minimum tax on capital gains.

The derivation of net cash flows associated with the installment sale is reported in table 2. Column I indi­cates the respective years of the installment period with year 0 reflecting the present period. Column 2 indi­cates the flow of principal payments-$70,000 down and $18,000 annual payments. Column 3 indicates the amount of each principal payment that is considered long-term, taxable capital gain-one-half of 80 percent of each payment. Column 4 indicates annual interest receipts-7 percent of the remaining loan balance in each year. Column 5 indicates the ordinary income tax obli­gation on interest and capital gains assumed to be paid in the same year, retaining the assumption that the seller's other ordinary income is zero each year. Column 6 indicates the minimum tax. Column 7 indicates the

annual net cash flows associated with the installment sale-principal plus interest less the tax obligations.

The annual net cash flows in column 7 must be dis­counted to a present value to conduct the profitability analysis. A specific discount rate (e.g., 5 percent, 10 percent, 15 percent) is used for the net present value method while the IRR method seeks the discount rate which equates the present value of the cash flows from the installment sale (PVis) to the present value of the cash sale (PV cs) which in this case is $I 93,208. A dis­count rate of 5 percent yields PVis = 233,797. The net present value is

NPVis = 233,797- I 93,208 = 40,589.

Hence, the installment sale is judged to be profitable, if the seller's after-tax opportunity cost is 5 percent. The (NPVis) declines to $7,282 for a 1 0-percent discount rate and to(-) I6,8I6 for a IS-percent discount rate. The IRR falls between 10 and 15 percent and is found to be 11.36 percent. This result indicates that the install­ment sale is more profitable than the cash sale as long as the seller's after-tax required-rate-of-return is less than 11.36 percent. Opportunity costs above 11.36 percent indicate the cash sale is more profitable.

Table 2-Deriving net cash flows for installment sales

Principal Taxable Regular tax on Minimum Net cast flow Year payments capital gain Interest (3)+(4) tax (2)+(4)-(5)-(6)

( 1) (2) (3) (4) (5) (6) (7)

Dollars

0 ..................... 70,000 28,000 7,100 2,700 60,200 1 ..................... 18,000 7,200 12,600 4,324 0 26,276 2 ..................... 18,000 7,200 11,340 3,971 0 25,369 3 ..................... 18,000 7,200 10,080 3,618 0 24.462 4 ..................... 18,000 7,200 8,820 3,262 0 23,558 5 ..................... 18,000 7,200 7,560 2,950 0 22,610 6 ..................... 18,000 7,200 6,300 2,635 0 21,665 7 ..................... 18,000 7,200 5.040 2,320 0 20,720 8 ..................... 18,000 7,200 3,780 2,036 0 19,744 9 ..................... 18,000 7,200 2,520 1,758 0 18,762

10 ..................... 18,000 7,200 1,260 1,277 0 17,893

PROFIT RESPONSES TO DATA VARIATIONS

The net present value model can be used to evaluate how thp profitability of the installment sale responds to changes in financing terms and other variables. These variables include: I) the down payment requirement, 2) the seller's annual taxable income, 3) the rate of inter­est on the installment contract, 4) the length of the installment period, 5) the size of capital gains relative to the basis, and 6) the use of partial amortization and balloon payments.

46

The profitability responses are illustrated in table 3 under the heading "without income averaging." Column I reports the levels of variables, net present values and the IRR for the base solution. Other columns report profit measures for a change in a single variable with the values of other variables held at their base levels. Hence, for consistent interpretation the results of columns 2 through 7 should be compared only to the results in column I.

The profit responses depend largely on the effects of changes in the variables on the level and timing of net cash flows associated with the installment sale and on the size of the discount rate relative to the interest rate on the installment contract. Column 2 indicates that a decline in the down payment from 28 percent to I 0 percent reduces the IRR to IO.SI percent, while (NPVis) increases for the S-percent discount rate and declines for the I 0-percent and IS-percent rates. The NPV for the S­percent discount rate increases, because of the larger loan balance earning the higher 7 percent installment in· terest rate over the installment period. As the discount rate increases, the installment interest rate becomes less favorable.

Column 3 indicates that the presence of $20,000 of other ordinary income in each year reduces the IRR to 8.87 percent and lowers (NPVis) for each discount rate. The presence of other ordinary income increases the average tax rate charged on the installment income, thereby reducing its profitability. Column 4 indicates that lengthening the installment period from IO to 20

years reduces the IRR to 9.52 percent, while (NPVis) increases for the S-percent discount rate and declines for the IO-percent and IS percent rates. The (NPVis) for the S-percent discount rate increases because of the longer period over which the higher 7-percent install­ment interest rate is earned. As the discount rate increases, the installment interest rate becomes less favorable.

Column S indicates that increasing the current mar­ket value to $SOO,OOO, which in turn increases the gross profit percentage ($4SO,OOO/$SOO,OOO = 90 percent), increases the IRR to I2 percent. The (NPV is) increases for the S-percent and I 0-percent rates, but becomes more negative for the IS-percent rate. Column 6 indicates that decreasing the rate of interest on the installment note to 6 percent decreases the IRR to I0.40 percent and decreases (NPVis) for each discount rate. Column 7 indicates that amortizing only one-half of the initial $I80,000 loan balance and requiring a balloon payment of $90,000 in year IO reduces the IRR to 9.66 percent and reduces (NPVis) for each discount rate.

INCOME AVERAGING

The Internal Revenue Code and tax regulations also permit taxpayers to average their income in determin­ing their tax obligations if their income varies widely from year-to-year. To determine eligibility for using income averaging, a taxpayer first computes his average income for the previous 4 years. This average income is then multiplied by I20 percent. The difference between the current income and I20 percent of the average in­come from the previous 4 years is called averageable income. Income averaging can only be used if average­able income exceeds $3,000.

In the previously mentioned case, where the seller has no other ordinary income, using income-averaging only on the cash sale reduces the seller's regular tax obligation from $4S,I80 to $2I,900. (see appendix) The minimum tax increases, however, from $II,6I2to $I3,3S8. The net effect is a reduced tax obligation which increases the present value of the cash sale from $I9J,208 to $214,742-an increase of $2I,S34. The increased pres­ent value of the cash sale means that the net present value of the installment sale has declined by $2I ,S34

for all discount rates. A revised IRR is found by deriv­ing the discount rate that equates the present value of the cash flows associated with the installment sale to the present value of the cash sale with income averaging-in this case $2I4,742. For case 1 conditions, which are described by the cash flows in table 2 and the charac­teristics in column I of table 3, the revised IRR is 7.66 percent.

Hence, income averaging with cash sales lowers the internal-rate-of-return of the installment sale by about 3.7 percentage points-about a 33-percent decline in profitability. The effects of income averaging on an installment sale's profitability for other variations are indicated in table 3 under the heading "with income averaging." The profitability of installment sales declines in all cases, although by differing amounts. The decline in profitability is least in variation 3, where the seller is assumed to have other ordinary income, and is greatest in variation S, where the sales value and gross profit percentage are larger.

INFLATION EFFECTS

The impact of inflation is important and can signifi­cantly affect the profitability of an installment sale. Because the sales value and financing terms are fixed at the time of the original transaction, the seller essentially holds a fixed-income security. Expected inflation or deflation can be accounted for by changing the install­ment rate of interest and the investor's required-rate-of-

return to reflect the inflation premium. However, fixed­income securities may experience inflation risk if unan­ticipated changes occur in the rate of inflation.

Suppose that the interest rate specified in an install­ment sale contract (for example, 7 percent) contains no premium or allowance for inflation. That is, a zero rate of inflation is anticipated. Further suppose that a S-

47

percent general rate of inflation actually occurs. This rate implies that the purchasing power of the fixed inflow of dollars associated with the installment con­tract declines by 5 percent annually or, alternatively, that the nominal value of income earned on an alterna­tive investment increases by 5 percent annually. The general result is to reduce the profitability of the install­ment sale, with the magnitude of the reduction approxi­mated by the expected rate of inflation (1).

Without income averaging, the IRR of the install­ment sale declines to 6.36 percent; with income averag­ing, the IRR declines to 2.66 percent. Changes in net

present values can be evaluated by adjusting the discount rate by the amount of the change in the rate of inflation. Profitability responses to other changes in rates of infla­tion or changes in rates of deflation can be estimated in a similar manner.

In the case of farmland, the inflation risk interacts with the potential loss of real capital gains on the farm's value between the time of sale and receipts of payment. The seller's use of a variable interest rate plan in the installment might help offset some of the general infla­tion risk, but would not adequately cope with the loss of capital gains.

IMPLICATIONS

It is important to note that the specific numerical results that have been derived hold only for the fmanc­ing terms and other conditions assumed in the case anal­ysis. Analogous results are needed to evaluate other cases with different conditions. Nonetheless, the numerical results are generally consistent with the kinds of profit­ability responses expected for installment sales, as changes occur in financing terms and in other investor characteristics, although the effect of the investor's discount rate must be carefully considered.

It is also important to note that the net present value model can be used to evaluate installment profitability when changes in the levels of several variables occur simultaneously. It is unlikely that all but one decision variable is held constant in contract negotiations be­tween buyer and seller. Trade-offs between the sale price and the contract rate of interest are an example.

The seller may prefer a higher sale price and lower interest rate because of the lower tax obligation on capital gains relative to ordinary interest income. In contrast, the buyer may prefer a lower sale price and a higher interest rate to reduce ordinary income tax obli­gations. Increasing the interest rate in response to a longer loan maturity exemplifies another trade-off, as does shortening the loan maturity when downpayments are lower.

How do the results in the case example affect the seller's viewpoint on installment fmancing? The effects may be especially important in periods of rising inflation and for seller's who can effectively use income averaging. Increasing rates of inflation that are unanticipated directly reduce the profitability of installment sales, as is the case for any fixed-income security. The greater the unanticipated increase in inflation, the greater the

Table 3-Profitability responses of installment sales to selected changes in financing terms and tax position

Variations in-Down- Taxable

Base payment income Installment Market Interest Balloon Variables period value rate payment

( 1) (2) (3) (4) (5) (6) (7)

Basis ($) .......................... 50,000 50,000 50,000 50,000 50,000 50,000 50,000 Current market value ($) • 0 ••••••••••• 250,000 250,000 250,000 250,000 500,000 250,000 250,000 Downpayment (%) ••••••••••••••••• 0 28 10 28 28 28 28 28 Installment interest (%) .............. 7 7 7 7 7 6 7 Installment period (yrs) .............. 10 10 10 20 10 10 10 Other taxable income ($) ............. 0 0 20,000 0 0 0 0 Balloon payment ($) ................ 0 0 0 0 0 0 90,000

Without income averaging NPV i = .05, ($) ................... 40,589 44,702 23,970 47,464 81,438 34,410 39,542 NPV i = .10, ($) ................... 7,282 3,443 -5,911 -4,027 19,588 2,114 -2,384 NPV i = .15, ($) ................... -16,816 -26,415 -27,492 -34,643 -25,100 -21,254 -30,628 IRR (%) ......................... 11.36 10.51 8.87 9.52 12.00 10.40 9.66

With income averaging NPV i = .05, ($) ................... 19,056 23,168 12,108 25,930 20,504 12,907 18,088 NPV i = .10, ($) ................... -14,252 -18,091 -17,773 -25,561 -41,346 -19,420 -23,918 NPV i = .15, ($) ................... -38,350 -47,949 -39,354 -56,177 -86,035 -42,788 -52,162 IRR (%) ......................... 7.66 7.61 6.82 7.19 6.49 6.78 6.90

48

change in profitability of installment sales. In addition, the use of income averaging further diminishes the profitability of installment sales and warrants serious consideration as an alternative to installment sales. As the results in table 3 indicate, the greater the capital gains relative to ordinary income, the greater the payoff from income averaging.

In the absence of rising inflation and income averag­ing, the installment sale remains profitable for sellers whose after-tax opportunity costs are generally less than 9 percent. Only as opportunity costs begin to exceed the 10 to 12 percent range do cash sales become more profi­table. While it is not clear which range of opportunity costs best reflects the investment opportunities used by sellers of farm real estate, many observers would likely argue that retiring farmers generally reinvest their sale proceeds in savings accounts, certificates of deposit, or fairly risk-free Government or agency bonds. For these farmers, the installment sale is likely a good choice, as long as the inflation risk is low.

A complete analysis of installment sales requires con­sideration of their risk and liquidity effects. Inflation risk has already been identified. In addition, the buyer's low equity position increases default risk, although the

seller can presumably account for part of this increased fmancial risk by adding a risk premium to the install­ment rate of interest or to the required-rate-of-return. This financial risk is further offset by the simplified foreclosure procedures on many seller contracts and deeds of trust, and by the rising values of real estate pledged as collateral during inflationary periods. Invest­ment liquidity in seller-financing is also low due to the lack of organized markets for selling the contracts. As a result, the seller may find his investment locked into the installment sale for many years unless he is willing to accept a relatively large discount when selling the con­tract.

It is also interesting to note the effects of the mini­mum tax on capital gains and other types of preferential income which was introduced in 1969 and extended in 1976. It clearly favors the installment sale and tends to increase the internal-rate-of-return for each variation in table 3 by about 1.5 percentage points.

Hopefully, the procedures of profitability analysis suggested here provide the seller-investor with a more definitive method of evaluating the merits of installment sales. If so, then the results are improved information and greater confidence in decisionmaking.

APPENDIX

Several hidden traps should be noted in determining compliance with the 3-percent rule. Earnest money deposited in a year prior to the year of sale is treated as though received in the year of sale. If the fmance con­tract stipulates an interest rate of less than 6 percent, the IRS will impute interest at a 7-percent rate and corre­spondingly reduce the purchase price-which in turn will reduce the 30-percent qualifying downpayment. The

· buyer's payment of the seller's legal obligations (for example interest, taxes) is considered money received in the year of sale. Receipt of a corporate buyer's corpo­rate paper is also income in the year of sale if there is a ready market for such paper. If the seller's basis is less than existing mortgage on the property, the difference is treated as income in the year of sale.

The income-averaged tax obligation is found in the following series of steps which are illustrated in IRS guidelines. First find the tax on the sum of one-fifth of averageable income plus 120 percent of average income for the previous 4 years. From this tax obligation, sub­tract the tax obligation on 120 percent of the average income for the previous 4 years. Multiply the difference by 5 and to this product add the tax on 120 percent of the average income for the previous 4 years.

To illustrate, consider the application of these steps to case 3 in table 2 where the seller's annual ordinary in­come is presumed to average $20,000.

Taxable income for 1977 Less 120 percent of $20,000

(average income) Equals averageable income

Taxable averageable income equals 1/5 of averageable income ($19,200) plus 120 percent of average income ($24,000)

Tax on $43,200 is Less tax on $24,000 which is Equals

Tax on 1 20% of average income {$24,000) is

Plus total tax on averageable income (5 X 8,016)

Equals income-averaged tax

120,000

24,000 96,000

43,200

13,676 5,660 8,016

5,660

40,080 45,740

Without the farm sale, the taxpayer would only pay taxes of $4,380 on his $20,000 ordinary income. Hence, the farm sale with income averaging increases his tax obligation by $41,360. In comparison, the sale without income averaging, and with another $20,000 of ordinary income would increase his tax obligation by $53,200.

The initial case situation and other variations in

49

table 2 assume that the taxpayers annual ordinary income is zero. The income-averaged tax obligation is found in the same manner as above, although average income is assumed to be zero. Under this condition the

seller's regular tax obligation on the cash sale is reduced from $45,180 to $21,900. The total tax obligation, in­cluding the minimum tax is reduced from $56,792 to $35,258.

LITERATURE CITED

(1) Aplin, R. D., G. L. Casler and C. P. Francis (7) Levi, Donald R. Capital Investment Analysis. Grid, Inc., Colum- Agricultural Law, third edition. Columbia, Mo., bus, Oh., 1977. Lucas Brothers, 1976.

(2) Boehlje, M. D. (8) Nelson, A. C., W. F. Lee and W. G. Murray "Use of the Exchange and Land Contract in Agricultural Finance, 6th edition. Ames, Ia, Real Estate Transfers," Jour. of the Amer. Soc. Iowa State Univ. Press, 1973. of Farm Managers and Rural Appraisers, Vol. (9) Reinsel, R. D. 36, No. I. Apr. 1975. "Effect of Seller Financing on Land prices,"

(3) Elefson, F. V. and P. M. Raup Agricultural Finance Review, U.S. Dept. Agr., Financing Farm Transfers with Land Contracts. Res. Serv.,July 1972, Vol. 33. North Central Regional Publication No. 122, (10) Suter, R. C., P. J. Scaletta and C. J. Thomsen. Agricultural Experiment Station, Univ. of "The Installment Land Contract: Legal Pro-Minnesota, Apr. 1961. visions and Economic Implications," Jour. of

(4) Gale, J. F. the Amer. Soc. of Farm Managers and Rural "Installment Land Contracts in Financing Appraisers. Vol. 35, No.2, Oct. 1971. Farm Real Estate Transfer," Agricultural Fi- (I 1) U.S. Department of Agriculture, Economic Re-nance Review. ERS-USDA, Vol. 24, 1963. search Service

(5) Hill, E. B. and M. Harris. Farm Real Estate Market Developments. ERS, Family Farm Transfers and Some Tax Implica- CD-81, July 1976. tions. North Central Regional Publication 127, (12) Economic Research Service Agricultural Experiment Station. Michigan Agricultural Finance Statistics. AFS-1, ERS, State Univ., Sept. 1961. May 1973.

(6) Hopkin, J. A., P. J. Barry and C. B. Baker (13) Economic Research Service Financial Management in Agriculture. Danville, Balance Sheet of the Farming Sector. ERS, Ill., Interstate Printers and Publishers, 1973. Agr. Info. Handbook No. 389, July 1976.

so

News Notes·

Farmers Home Administration's New Unified Management Information System

Roy E. Bottles and Harold K Street I

The Farmers Home Administration (FmHA) is com­puterizing and streamlining its internal management. It has adopted a Unified Management Information System (UMIS) which is expected to result in savings to FmHA and its borrow~rs. The Treasury estimated the savings at $20 million to $60 million per year. These savings will come from a new method of disbursing FmHA loan funds and increased productivity of the Agency's field staff. UMIS is expected to significantly reduce paper­work for employees in FmHA County Offices, leaving them more time for providing credit for farmers and other rural people. UMIS may also serve as a model for other Federal agencies, developing better and less costly delivery systems for their public service programs. Potential for analysis of FmHA programs is greatly enhanced by UMIS. Data for research in the progress of borrowers over time can be obtained at low cost.

Most of FmHA's field staff is based in county offices, the basic units for delivering most of the programs of the agency-the farm and rural credit service of the U.S. Department of Agriculture (USDA). FmHA has about I ,750 county offices, each serving one or more counties and thus covering all rural areas of the United States. County supervisors and their staffs deal directly with the agency's clients. Applications for FmHA loans and grants are received, and in most cases approved, at the county level.

FmHA has evolved from its original purpose as a farm lender of last resort to the point where more than three­fourths of its lending is to nonfarm rural people for housing, community facilities, and job-producing busi­ness and industry. Its growth has been particularly rapid in the past 10 years. During that period, its loans out­standing have grown from about $3 billion to nearly $20 billion. Its lending is expected to total a record $6.3 bil­lion in fiscal year 1977.' The size of FmHA's staff has

1 Battles is an Information Specialist with the Farmers Home Administration and Street is Assistant Director of Information, Farm Credit Administration.

'Total does not include $700 million of livestock loans and business and industrial loans made by private lenders and guaran­teed by FmHA.

not kept pace with the growth of its lending. Its field force is smaller now than it was 10 years ago, even though it was increased during the past fiscal year and is due for another increase during fiscal1977.

FmHA's UMIS includes the following: 1) A computerized information retrieval system with

terminals in county offices due to be tested in one State, beginning in late 1978. It will provide nearly all of the information on borrowers now filed in county offices.

2) A Loan Disbursement System (LDS) is now in operation. Under LDS, loan funds are withdrawn from the Treasury in the amount needed by the borrowers.

3) A Work Measurement System (WMS), in partial operation, that determines how much time county office personnel spend in making and servicing loans and at other tasks.

Computer Network

The timetable for the UMIS computer network calls for installation of the central computer in 1978. Termi­nals are to be placed in county offices in one State for a 6-month pilot test due to begin in late 1978.

UMIS will have !3 subsystems: 5 to be put into effect first, 8 later. Those in the first group and what they are expected to accomplish are:

l) Applicant screening and tracking. Following status of each application, reserving funds for future periods, identifying applications that have exceeded normal proc­essing time.

2) Program loan accounting, disbursing, and servicing. Obligating and disbursing loan funds, keeping borrower balance and payment history and characteristics, main­taining servicing actions, identifying delinquent bor­rowers, and maintaining conveyance and foreclosure activity.

3) Investor accounting. Maintaining investor balances, projecting future disbursement requirements, identify­ing guarantee arrangements.

4) Acquired property management. Maintaining and projecting inventory, identifying properties being fore­closed or conveyed, keeping cost history, developing characteristics of borrowers whose property is acquired.

51

5) Management Operating Information. Measuring accomplishments to program objectives, identifying deviations, finding areas needing attention.

Systems in the second group and their expected accomplishments are:

1) Administrative support. Keeping inventory of real property, office space, forms, and vendor price catalogs and performance records. Identifying data processing costs.

2) Budget and appropriation accounting. Control­ling apportionment and distribution of funds and gen­erating budget reports.

3) General ledger/responsibility reporting. Producing agency and State reports and income statements for each type of loan.

4) Personnel Productivity. Measuring personnel use relative to standards and distributing payroll costs to types of loans.

5) Program Evaluation. Measuring accomplishments, identifying and forecasting variances from targets and forecasting future activity.

6) Budget simulation model. Analyzing funding level changes and forecasting future cash balances and require­ments.

7) Cash flow model. Projecting impact of changes in

52

activity in individual types of loans. 8) Personnel requirements model. Forecasting person­

nel requirements for changing loan program levels and preparing schedules for budget submission.

Benefits and Savings

With UMIS in full operation, FmHA expects that more of its applicants and borrowers, especially farmers, will receive more and better financial counseling from county supervisors and their staffs. Applicants' and borrowers' questions will also be answered more quickly and more completely. These benefits, as FmHA see it, will extend to rural communities and businesses in those communities. These benefits include rural banks, which should help as more borrowers get into better financial condition, since FmHA requires its borrowers to "grad­uate" to commercial sources of credit when they can meet the commercial lenders' rates and terms. The annual operating budget for UMIS is estimated at $10 million. The annual value of increased productivity resulting from UMIS is estimated at $10 million to $20 million. Annual interest savings of $20 million to $50 million are possible when the full capabilities of UMIS are operational nationwide.

New Survey of Terms of Bank Lending to Farmers

Emanuel Melichar 1

In February 1977, the Federal Reserve System started a new quarterly survey of business, construction, and nonreal-estate farm loans made by commercial banks. A panel comprised of350 banks was chosen to provide data on loans of $1 ,000 or more made during the first full business week of February, May, August, and November (except that member banks report their business loans each month, and some very large banks were asked to report for only 2 or 3 days of the survey week to reduce reporting and processing burdens). For the purpose of analysis, these sample data are blown up to secure estimates of the amount, terms, and characteristics of loans at all insured commercial banks. For farm loans, the blowup factor for each stratum is the ratio of the outstanding amount of nonreal-estate loans to farmers at the sampled banks to the amount at all banks, as report­ed on the latest available quarterly report of condition.

A description of the new survey, including informa­tion on the objectives, sampling procedures, and Febru­ary 1977 results, was published in an article, "Survey of Terms of Bank Lending," in the May 1977 issue of the Federal Reserve Bulletin. Selected data from each survey are issued as the Federal Reserve Board's statistical release, G.I4, "Survey of Terms of Bank Lending." Every third issue of this monthly release presents the farm loan survey data. To obtain a reprint of the article or to get on the mailing list for the release, write to Publications Services, Federal Reserve Board, Washington, D.C. 20551. In addition, principal results from the latest available quarterly survey are published in table 1.35 in each issue of the Federal Reserve Bulletin.

The new survey of farm loans yields the following data: Number and dollar amount of loans made (and thus also the average size), average maturity, and average effective interest rate. These data can be tabulated or analyzed by known bank characteristics, such as region or deposit size; by surveyed loan characteristics, such as purpose or participation status; and by classifications based on the survey data, such as loan size or maturity class.

Previously, such data and analyses covering farm

' Board of Governors of the Federal Reserve System.

loans nationally were available only from special surveys of loans that were outstanding on June 30. These sur­veys were conducted in 194 7, 1956, and 1966 (see "Bank Financing of Agriculture," Federal Reserve Bulle­tin, June 1967). The new survey thus updates certain information about farm loans by more than a decade, and will henceforth keep such data far more current than in the past.

Detailed descriptions and analyses of the new data will, therefore, be of considerable interest. In such work based on a quarterly survey of loans, however, an im­portant consideration is that seasonality in the volume of farm lending varies among regions and among differ­ent types of loans. Before initiating extensive analyses, it seems best to await the availability of data from four quarterly surveys, which can then be combined and regarded as representative of a full year of lending nationally. The relationships between variables, such as interest rates or maturity and the available bank and loan characteristics, will then be examined through tabu­lations and multivariate statistical techniques. Data on more than 10,000 sample loans will be available for these analyses. A preview of the data that will be forth­coming and the relationships that will be explored are provided in table 1.

Preliminary Results

For the Nation, the average loan size was $12,000 (loans less than $1,000 are excluded), the average inter­est rate was 8.8 percent, and the average period of maturity was 9 months. The rate and maturity averages apply to the dollar amount loaned; that is, in calculating these, the data for each loan were weighted by the dollar amount of that loan.

Classification of the loans by the deposit size of the bank lending indicates that most farm loans were made by relatively small banks. The dollar amount loaned by large banks was more significant than loan numbers. On the average, loans at the large banks were much larger, carried lower interest rates, and were much more likely to have short maturity periods and a floating interest rate, and to have been made under a commitment (a line of credit known to the borrower).

53

Table 1-Terms of bank nonreal-estate loans to farmers, first half of 1977

(Ba91!d on sample survey of loans made during February 7-12 and May 2-7 I Percentage of dollar amount of loans-

Percent of total Average loans made Average effective That consists of

loan interest Average With With Made participations Classification of loan (thou- rate maturity maturity floating under a originated by-

Number I Amount sands of (per- (months) of 12 interest commit-dollars) cent) months rate ment Report-: I

or more ing bank Others

All loans .............•.....•.. 100 100 12 8.8 9 19 14 34 6 6

Total deposits of bank (millions of dollars):

Under 5 .......•............ 6 3 7 8.6 8 30 9 3 16 • 5 to 9 ........... 0 •••••••••• 29 18 8 8.9 11 29 2 18 6 10 10 to 24 • • • • ... • • 0 ... 0 ........... 35 27 9 8.8 9 21 . 16 3 2 25 to 49 ........................ 0 14 12 10 8.9 9 23 • 55 2 1 50 to 99 7 6 11 9.4 21 34 • 20 • 3 ..................... 100to 249 ......... 0 .......... 4 10 28 9.2 10 17 4 31 2 10 250to 499 ..................... 1 5 36 8.4 7 4 23 50 9 19 500to 999 0 ............. 0 ....... 1 7 68 7.9 5 1 52 85 39 19 1,000 and over 3 11 49 8.1 6 4 77 63 . 2 •• 0 ........ 0 ....

Amount of loan· (dollars): 1,000 to 2,499 31 4 2 9.0 7 15 2 21 • .

....... 0 ...... 0 •••

2,500 to 4,999 23 6 3 9.1 9 26 3 18 • 2 ......... 0 ......

5,000 to 9,999 ............ 0 •••• 20 11 6 9.0 9 25 3 27 1 1 10,000 to 14,999 ........... 0. 8 8 12 9.0 9 28 8 21 1 2 15,000 to 24,999 ............ 0 8 13 19 9.0 8 13 3 23 3 7 25,000 to 49,999 .............. 6 16 33 8.8 12 26 5 27 5 4 50,000 to 99,999 ...... 0 •••••• 3 15 66 8.7 12 26 8 37 7 13 100,000 to 249,999 • 0 •••••••• 1 12 138 8.7 7 10 17 43 8 12 250,000 to 499,999 * 4 323 8.3 18 17 42 60 18 12 ••• 0 •••• 0.

500,000 to 999,999 . 3 667 8.3 6 18 45 88 32 14 0 0 .........

1,000,000 and over .....•...•. * 8 2,380 8.1 5 * 66 58 14 2

Maturity (months): Payable on demand ........... 2 6 36 8.3 --- --- 22 37 6 3

Under 4 ....... 0 .............. 21 22 12 8.9 2 - - - 22 42 10 11 4 to 6 ....•......•......•. 39 32 10 8.8 6 - -- 8 19 7 7 7 to 9 .............. · · · · · · 11 12 13 8.5 8 -- - 27 45 10 7 10 to 12 .................. 21 22 13 8.7 11 60 10 42 * 2 13 to 36 .................. 5 3 7 9.2 24 100 5 36 • 1 37 and over ............... 2 3 27 9.6 77 100 2 42 • 2

Effective interest rate (per cent): Under 7.0 ................. • 4 149 6.5 7 3 76 65 12 4 7.0 to 7.9 ................. 2 7 37 7.6 8 16 50 66 30 4 8.0 to 8.9 ................. 45 45 12 8.5 8 17 13 31 6 10 9.0 to 9.9 •...........•...• 44 40 11 9.3 11 23 4 28 2 4 10.0 to 10.9 ............... 6 3 6 10.3 10 24 6 41 • 2 11.0 and over .............. 2 1 6 13.1 27 68 * 9 • •

Method of interest charge: On original amount ........... 3 1 6 11.2 33 66 -. - 9 2 • On remaining balance •••••• 0 •• 97 99 12 8.7 9 19 15 35 6 6

Interest rate over life of loan: Floating .................... 4 14 46 8.0 6 3 100 74 11 3 Predetermined •.•.....•.•..•• 96 86 11 8.9 10 22 --- 28 5 7

Commitment status: Made under commitment ...... 23 34 18 8.6 11 17 31 100 11 5 No commitment •••• 0 •••••••• 77 66 10 8.9 9 20 6 --- 4 7

Participation status: Participation originated by-

Reporting bank •• 0 0 •••• 0 ••• 1 6 63 8.2 4 • 26 61 100 ---Others ........................ 2 6 37 8.6 5 2 6 29 --- 100

Not a participation •••••.••• 0. 97 88 11 8.8 10 22 14 33 --- ---Purpose of loan:

Feeder livestock ............. 10 15 18 8.4 6 14 22 40 15 13 Other livestock •• 0 •••••••• 0 0 0 12 14 14 8.5 12 17 18 31 8 6 Other current operating expenses 49 39 10 8.8 7 12 10 36 2 4 Farm machinery and equipment . 16 12 9 9.2 17 49 5 24 1 • Other or not known .......... 13 20 18 8.8 12 22 20 36 8 9

*Less than 0.5 percent.

54

Tabulation of the loans by size shows that most farm loans were relatively small, with over half being less than $5,000. However, three-fourths of the money loaned was in notes ranging from $5,000 to $250,000. Over this wide range, average interest rates and many other characteristics did not vary greatly. But loans of $250,000 or more-which accounted for 15 percent of total dollar volume-had significantly (;ywer average interest rates, and the rates were much more likely to be floating. Still, the average rate on the very large farm loans was considerably above the prime rate of 6.25 per­cent that prevailed at the Nation's large banks during the survey periods.

Only 7 percent of the loans made had a maturity of more than 1 year. Because such loans remain in a bank's portfolio for a longer time, a survey of outstanding loans would show that a much larger proportion of farm loans were in this maturity bracket. The longer term loans had a higher average interest rate and were most likely to be farm machinery loans.

Relatively few farm loans, however, had effective interest rates in the upper ranges associated with some consumer and business lending. (Loans purchased by banks, such as loans purchased from farm machinery dealers, were excluded from the surveys. However, personal and consumer loans to farmers were included.) On 3 percent of all loans, banks used the discount or add-on method of calculating interest charges.

The surveys will provide the first reliable basis for estimating the gross flow of bank loans to farmers. Farm finance analysts at the macrolevel have long lamented the lack of that statistic, which is available monthly for lending by production credit associations (PCA's). From the February and May data, one might tentatively esti­mate that during the first half of 1977 banks made about 1.9 million nonreal-estate loans to farmers, totaling about $23 billion. Loans made by PCA 's during this period totaled $11.1 billion.

Analytical Considerations

As previously mentioned, a key factor to be con­sidered (whenever interpreting quarterly survey results) is the possible effect of diverse seasonal influences on survey averages.

For example, suppose that interest rates are stable, but are lower in the South than in the North. Suppose also that the February survey contains a higher propor­tion of southern loans than does the May survey. The national average rate will then be higher in May than in February even if rates had not changed in either region. Multivariate analyses of data for a full year may help to quantify the nature and extent of such problems and may indicate how the quarterly data should be tabulated and presented to minimize such distortions.

Earlier it was noted that average interest rates at large banks were lower than those at small banks in the first half of 1977. Previous survey work has shown, however,

that the "most common" rate charged on farm loans at large banks tends to fluctuate considerably with changes in monetary conditions and the national prime rate, whereas the rate charged at small banks tends to move comparatively less and also more slowly. During periods of monetary restraint, therefore, average rates on loans at large banks may rise above those at small banks (as was apparently the case in the spring of 1974 ).

Similarly, since large loans tend to be made by large banks, the new survey will undoubtedly document dif­ferences in the cyclical behavior of rates among various size classes of loans. Thus, users of the survey data may miss significant cyclical developments if they follow only the global averages for all loans or for all banks combined. The statistical release also presents data by six loan-size classes and by two bank-size classes. The latter classes currently contrast 48 large money-center banks with all other banks. (The 48large banks are sim­ply those in the survey's certainty stratum-the banks with the largest outstanding business loan volume in June 1974.) This demarcation may or may not prove optimal for the purpose outlined above, and will be revised if necessary after analysis of survey results over a monetary cycle.

Users should also be aware that under some circum­stances a single large loan that falls into the sample can heavily influence some of the reported survey results. The sampling plan tends to minimize this effect, in that large banks which are more likely to make large loans are in general sampled more heavily than small banks. Thus, loans made by large banks are generally assigned lower blowup factors.

Still, in the limited experience to date there have already been two cases of large loans, each of which, represented about 4 percent of the total estimated dollar amount of loans made during the survey week. In a detailed tabulation, the characteristics of such a loan may dominate the data in the cell in which it happens to fall. To the extent that the terms of the loan are unusual, such data will exhibit a large quarterly change. In the statistical release, in which all data are shown by loan-size classes, these effects are concentrated in the last size class-$250,000 and over. Thus, users of the release should not be surprised or unduly impressed by large quarterly changes in the survey data for that class. Users interested in current developments in the amount and terms of "large" farm loans should focus mainly on the next largest size class-$! 00,000 to $249,999.

A more serious problem can arise if one of the report­ing banks in the most lightly sampled stratum should happen to make a very large farm loan during a survey week. The blowup factor for farm loans in this stratum is currently about 185, and so a $!-million loan at one of these banks would account for about a fifth of the estimated total dollar amount of farm loans made nationally. Most of the banks in the stratum are small institutions that are neither likely nor, in many cases, legally able to make such a loan. However, since mem-

55

bership in the stratum was based on a low outstanding total amount of both business and farm loans rather than on the overall size of the bank, several reporting banks in this group could conceivably make a very large farm loan. If a significant case of this kind occurs in a future quarterly survey, it would result in an extraordi-. narily high total dollar amount of loans in the last size class-$250,000 and over. This would be a signal for users to exercise greater caution in using the overall national totals and averages reported for that quarter.

Finally, users of the statistical release will find that

56

the reported average maturities exhibit large variations both by loan classes in a given survey (as is evident in table I) and for the same class from one survey to the next. The explanation is that a few nonreal-estate farm loans have surprisingly long maturities (so far, three sample loans have had maturities of 20 years) and that these loans in turn can have a large impact on maturity averages, particularly if they carry a large blowup factor. Users interested in this characteristic should plan to observe data over several quarters before drawing conclusions about maturity levels and trends.

Federal Farm Credit Banks Consolidated Systemwide Bond

Dorrell M. Johnson and G~orge D. lrwkl'

The Fann Credit System has introduced a new bond instrument, the Federal Fann Credit Banks' consolidated systemwide bond. It is a joint obligation of all 37 Farm Credit Banks-the I2 Federal land banks, I2 Federal intennediate cn!dit banks, and I3 banks for cooperatives. The bonds are available in denominations of $I ,000, $5,000, $IO,OOO, $50,000, $IOO,OOO, and $500,000. The first issue was dated September I, I977. It was offered in two parts, a 5-year maturity of $532 million and a I2-year maturity of $430 million.

The Fann Credit System funds a majority of its lending activities through the sale of bonds and discount notes to public investors in the money markets. The security sales are managed through the Fiscal Agency of the Fann Credit Banks in New York City, which over­sees a private distribution network of about I90 security dealers across the country. As of June 30, I977, $34.5 billion in bonds and $I.2 billion in discount notes were outstanding. Total sales of both instruments for the year amounted to $35.7 billion.

Historically, each of the three bank groups had issued its own bonds. The 12 Federal land banks entered the market four times each year. Entries usually consisted of two issues, each ranging from $300 -million to $800 million in recent years. The 12 Federal intermediate credit banks participated monthly for a 9-month issue, ranging in size from $600 million to $1 billion per issue. They also entered twice a year with a tenn issue, varying from $300 million to $500 million. The 13 banks for cooperatives entered monthly with a 6-month issue of $400 million to $800 million, and twice per year with a term issue of $200 million to $400 million. The maxi­mum term was dictated by market conditions. Most Federal land bank issues were less than 20 years, and even shorter since 1970, while Federal intermediate credit banks and banks for cooperatives issues were less than 12 years.

In 1975, all 37 banks had joined together for the first time in issuing short-term discount notes. These were 5 to 150 day notes sold daily as a tool to add flexibility in

1 Research Division, Farm Credit Administration.

cash management. These notes have since been made available in 5 to 270 day maturity.

It is expected that, starting in I980, all bonds and discount notes will be on a systemwide basis, eliminating entries by the three separate systems. Prior to that time, consolidated systemwide bonds are expected to be con­fmed to 5-year and longer maturities.

Through the consolidation of bonds and discount notes, both debt instruments carry the full backing of all 37 banks. This strengthening is intended to further assure investors of continuation of the System record over the past 6I years of never failing to meet all interest and principal payments when due. This reputation enables the system to acquire funds at rates only mini­mally higher than paid by the U.S. Government. The new market instrument will create a stronger secondary market for Fann Credit System bonds, since the larger size of each issue will make trading easier. These two facts will help ensure that the Fann Credit System securities remain one of the most respected and desired securities in the market.

Consolidated issues also add flexibility to funding programs of the individual banks. Prior to September I, the Federal intermediate credit banks and banks for cooperatives entered the tenn bond market only twice a year because of their limited need for tenn debt. They had to accept a term derived by averaging the needs of the individual banks. The Federal land banks entered four times per year, usually with two tenn issues each time. Limited number of entries per year subjected each system to interest rates in the market at a very limited number of specific dates when sales were scheduled. By 1980, the new consolidated systemwide bond will be offered 16 times a year, replacing all current bond entries. There probably will be four different issues per offering. Each of the 37 banks of the Fann Credit Sys­tem will thus have many more funding options available. The flexibility afforded should help in assuring that the banks will continue to make funds available to a large, growing, variable farm sector in bad times as well as good.

The Fann Credit System provides loans to fanners,

57

farmer cooperatives, rural residents for housing, and certain agriculturally related businesses. It is com­prised of 12 Federal land banks, 12 Federal intermediate credit banks, 12 banks for cooperatives, and a Central Bank for Cooperatives. Created by Congress and initially funded with Federal appropriations, the Farm Credit

58

System paid back all the Government seed money and now is totally self-sufficient. Farm Credit System securi­ties are not backed by the Government. Nonetheless, the integrity of the Farm Credit System has been such that these securities are among the most sought after in the market.

Reports on Foreign Investment in the United States

Kenneth R. Krouse'

International investment events during the 1974 through 1976 period appear to have increased the rate at which agriculture and the food and fiber system is becoming internationalized. U.S. agriculture and other parts of the food and fiber system are attracting foreign investors as the importance of resources to produce, process, and transport food and fiber is increasingly recognized.

Heightened concern about foreign investment in the United States started in 1972 and 1973 when West Euro­pean and Japanese investors turned to U.S. agriculture, seeking a safe country and a means of diversifying their investment holdings. This concern increased in 1974 as oil producing-exporting countries started to accumulate substantial amounts of additional money (from a three­fold to fourfold increase in oil prices) that could be used to purchase goods and services, as well as to make invest­ments in other countries.

Congress and the Administration, after considerable discussion, passed and signed an act that focused directly on foreign investment. The Foreign Investment Study Act of 1974 (Public Law 934 79) called for identifica­tion, investigation, and analysis of foreign direct invest­ment and foreign portfolios investment in the United States, by the U.S. Departments of Commerce and Treasury.

Findings

The final reports to the Congress were provided in nine volumes by the Department of Commerce and in two volumes by the Department of Treasury. These reports are available for purchase from the U.S. Govern­ment Printing Office. Because the reports are extensive and cover various topics, readers of this publication will probably desire to be selective. The following is a listing of volume titles and highlights of the contents.

Foreign Direct Investment in the United States. Report to the Congress of the United States, prepared by the U.S. Department of Commerce, April 1976.

1 Economics, Statistics, and Cooperatives Service, U.S. Department of Agriculture.

For sale by Superintendent of Documents, U.S. Govern­ment Printing Office, Washington, D.C. 20402.

Vol. 1 and 2 sold as a set, price $6.00 Vol. 3, price $4.00 Vol. 4, price $2.00 Vol. 5, price $7.00 Vol. 6, price $4.00 Vol. 7, price $5.40 Vol. 8, price $4.00 Vol. 9, price $3.85

Volume 1: Report of the Secretary of Commerce to the Congress Summary Volume and Recommendations (by the Department of Commerce Staff)

Investment Perspectives Benchmark Survey of Foreign Direct Investment in

the United States, 1974 Industrial and Geographic Concentration of Foreign

Investment Reasons for Foreign Direct Investment Financing, Accounting, and Financial Reporting Management and Employment Practices U.S. Policies, Laws, and Regulations Concerning In­

ward Investment Taxation and Foreign Direct Investment Policies, Laws, and Regulations of Other Major Indus­

trialized Nations Concerning Inward Investment Foreign Investment in Land Technology Transfers Associated with Inward Foreign

Investment Economic Effects Data Collection on Foreign Direct Investment Conclusions and Recommendations The Foreign Investment Study Act of 1974

Volume 2: Report ofthe Secretary of Commerce: Benchmark Survey, 1974 (by the Bureau of Economic Analysis, U.S. Dept. of Commerce)

Classification of Data Table 1-List of Countries and Selected Data by

Country Table 2-List of Industries and Selected Data by

Industry

59

General Notes to Tables List of Tables Tables Grouped by Subject:

Part I: Foreign Direct Investment Position in the United States

Part II:

Part III:

Part IV:

Part V:

Part VI: Part VII:

Annex 1:

U.S. Balance of Payments Transactions Related to Foreign Direct Investment in the United States Foreign Parents' Shares in U.S. Affili­ates' Earnings and Related Items U.S. Affiliate Balance Sheet and Relat­ed Financial Data U.S. Affiliate Income Statement and Related Data Number of U.S. Affiliates Miscellaneous Data

Instructions for Completing Form BE-12, Survey of Foreign Direct Investment in the United States, 1974

Annex 2: Form BE-12 and Form BE-12-Part II (Additional)

Annex 3: BE-799-Industry Classification and Export and Import Trade Classification Booklet

Volume 3: Appendix A: Industrial and Geographic Concentra­

tion of Foreign Direct Investment in the United States (by the Conference Board)

Volume 4:

60

Appendix B: The Foreign Ownership of, influence on, and Control of Domestic Energy Sources and Supply (by the Federal Energy Administration)

Appendix C: Foreign Direct Investment in Selected Natural Resources (by Office of Inter­national Finance and Investment, Bureau of International Economic Policy and Research, DIBA, U.S. Dept. of Commerce)

Appendix D: Foreign Investment In the U.S. Com­mercial Fisheries Industries (by Eco­nomic and Market Research Division, National Marine Fisheries Service, National Oceanic and Atmospheric Administration. U.S. Dept. of Com­merce)

Appendix E: Foreign Investment In the U.S. Grain Trade (by Bruce H. Wright and Kenneth R. Krause, Economic Research Service, U.S. Dept. of Agriculture)

Appendix F: Foreign Banking In the United States (by Office of International Finance and Investment, Bureau of Interna­tional Economic Policy and Research, DIBA, U.S. Dept. of Commerce)

Volume 5: Appendix G:

Appendix H:

Appendix 1:

Volume 6: Appendix J:

Volume 7: Appendix K:

Volume 8: Appendix L:

Appendix M:

Volume 9:

The Reasons and Outlook for Foreign Direct Investment in the United States (by Arthur D. Little, Inc.) Processes, Mechanisms, and Methods of Financing Foreign Direct Invest­ment in the United States (by Booz, Allen and Hamilton, Inc.) Management and Employment Prac­tices of Foreign Direct Investors in the United States (by Business School, Georgia State University)

Tax Aspects of Foreign Direct Invest­ment in the United States (by Cole Corette and Bradfield)

Legal Restraints on Foreign Direct In­vestment in the United States (by David Morris Phillips, Associate Profes­sor of Law, Boston School of Law)

Foreign Investment In Land (by the Economic Research Service, U.S. Dept. of Agriculture) Legal Regulation of Alien Land Owner· ship in the United States (by Fred L. Morrison, Professor of Law, University of Minnesota)

Appendix N: Policies, Laws and Regulations of Other Major Industrialized Nation's Concerning Inward Investment (by Of­fice of Foreign Investment, DIBA, U.S. Dept. of Commerce, in cooperation with United States Foreign Service)

Appendix 0: Technology Transfer From Foreign Direct Investment in the United States (by Office of the Foreign Secretary, National Academy of Engineering and Assembly of Engineering, National Re­search Council)

Appendix P: Effects of Variations Between Accounting, Financial Reporting and Other Business Practices of U.S. and Foreign Investors on Foreign Direct Investment in the United States (by Touche Ross and Company)

Appendix Q: Foreign Government Agency Sources of Data on Foreign Investment in the United States (by Price Waterhouse & Co.)

Appendix R: Selected Bibliography tby Office of International Finance and Investment, Bureau of International Economic

Policy and Research, DIBA, U.S. Dept. of Commerce)

Foreign Portfolio Investment in the United States, Report to the Congress (prepared by the U.S. Treasury Department, August 1974).

For sale by Superintendent of Documents, U.S. Govern­ment Printing Office, Washington, D.C. 20402. Main re­port $2.30, appendix F and G by R. Shriver Associates, $5.70.

Chapter 1 Summary and Implications for the Future Chapter 2 Statistical Data Chapter 3 Economic and Institutional Factors Chapter 4 Effects of Foreign Portfolio Investment on

the U.S. Economy Chapter 5 Legal Aspects of Foreign Portfolio Invest­

ment Chapter 6 Comparison with U.S. Portfolio Investment

Abroad

Chapter 7 Adequacy of Current Statistical Reporting Requirements

Appendixes A. Statistical Tables B. Methodology for Survey C. Survey Questionnaire Forms D. Foreign Investment Study Act of 1974-PL 93-

479 E. Statement by the Honorable Gerald L. Parsky,

Assistant Secretary of the Treasury, before the Subcommittee on Commerce and Tourism, Senate Committee on Commerce, May 3, 1976

Appendix F: Institutional Aspects of Foreign Portfolio Investment in the United States (by R. Shriver Associates, Parsippany, N.J.)

Appendix G: Legal Aspects of Foreign Portfolio Invest­ment in the United States.

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