but 90 percent of their holdings must be in securities listed for trading on the Warsaw stock exchange or the OTC market, discouraging private placement of municipal bonds.

117. While many restrictions pertaining to portfolio holdings by institutional investors may be defensible in the early stages of development of capital markets in transition countries, they need to be relaxed as the market develops, less they hamper the emergence of a sound sub-national bond market.

# _(v) Tax regime for sub-national bonds_

118. Finally, the government needs to establish the tax regime for sub-national bonds.

119. In the US, municipal bonds are exempt from federal interest income tax. In ihe 1960s, municipalities began to use their favored access to credit markets to induce businesses to locate in their jurisdictions, through the issuance of industrial development bonds, used by municipalities to finance construction of structures that were then leased to the private sector, with the lease payments providing the revenues to meet debt service payments. This led to the rapid development of other forms of revenue bonds, ea,ch tailored to serve a specific constituency. By the early 1980s, the issuance of privateactivity bonds was out of control. In response to this development, the Tax Reform Act of 1986 considerably tightened eligibility criteria for private activity bonds. The main test is a joint test of uses-of-funds and of security interest: if more than 10 percent of a bond's proceeds are used for private purposes and if more than 10 percent of the debt service is derived, directly or indirectly, from a private use, the bond is considered a private activity bond. In order to qualify for tax exemption, a private activity bond must be within the state volume limit and must satisfy certain maturity restrictions. (The state volume lirmit is et at the greater of $50 per capita or $150 million). Tax exemption is automatically granted to private activity bonds within that limit. However, exempt facility bonds are excluded from the volume limit and can be issued in tax exempt form in any amount. These exempt facility bonds include airports, docks and wharves, solid waste facility, etc, as well as qualified mortgage bonds, qualified small-issue industrial mortgage bonds, qualified student loan bonds, qualified redevelopment bonds, and qualified non-profit organization bonds (see Fortune 1992, op. cit.).

120. Tax exemption for municipal bonds is subject to three main criticisms. The first criticism is that tax exemption induces unnecessary volatility into municipal bond yields: it narrows the market for municipal bonds and makes it more sensitive to change in the distribution of investable funds between individuals and financial institutions, and to other factors affecting financial markets. Also, tax exemption introduces variability in the value of the capital-cost subsidy enjoyed by municipalities. Empirical evidence of the interest rate ratio for municipal bonds of various maturities in the US shows that municipal bond yields are more volatile than yields on US Treasury bonds (see Fortune, op. cit.). The second criticism is that tax exemption is economically inefficient, in that it encourages overproduction of public services and overuse of capital by the public sector. Estimates of the social cost of tax exemption based on 1980-85 US data shows t1he economic cost of tax exemption in terms of output foregone to be mild. The third criticism is that tax exemption is inequitable, because it erodes the vertical equity in t]he tax system by allowing the wealthy to avoid taxation in ways that are not available to the 32