GIFT AND LOAN CLAUSES: REGULATING THE PUBLIC/PRIVATE PARTNERSHIP
Why Is this Section One of the Most Important?
After 1837 many states enacted state constitutional (and local) reforms that reshaped American economic development public/private relationships. They continue to strongly affect the configuration and operation of our contemporary economic development practice. Why is this so important? First, state/local governments were committed to building transportation infrastructure and a strong state-level financial system (banks) to open up and finance economic growth. Hybrid public–private corporations were the chief EDO entrusted to implement those sub-state economic development strategies. Gift and loan clauses reconfigured that hybrid EDO. Second, core tools of economic development (eminent domain, tax abatement, loans/grants/tax-exempt bond financing) must conform to any redefinition of the public/private relationship. In an Age of Infrastructure, gift and loan provisions struck at the heart of economic development of that era.
The Panic began in 1837; economic growth did not resume until 1842—making the Panic one of the longest in our economic history. Before it was over eight states (Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi and Pennsylvania) and one territory (Florida) defaulted. Four states repudiated at least some of their debt (Arkansas, Florida, Michigan and Minnesota (Wallis, 2004). In effect, America had one of its worst binges of state bankruptcies—a public debt crisis of the first magnitude. The principal cause of these state defaults usually centers on state/local debt associated with our infamous canal and railroad infrastructure-related corporation charters. Scandals associated with bankruptcies of charter infrastructure corporations, the inside “crony politics,’ capture the media’s and the public’s attention. They were the problem that had to be fixed—or so it seems today.
While not every state defaulted, after the Panic nearly every state over the following decades amended their constitutions to insert some form(s) of “gift and loan” clause that limited the use of state funds for private corporations and individuals. As new states entered the Union these statutes were included in their initial constitutions, so that by the turn of the twentieth century all states, it is asserted (Tarr, 1998, pp. 110–13), had incorporated a form of gift and loan clause into their constitutions. Yet, as we shall discover, the clauses did little to stop public financing of private transportation infrastructure. They certainly changed its “form” (HEDO); the old-style corporate charter was left behind and in its place were new forms of public financing channeled to a new purely private organization: the modern corporation, which first appeared in 1850s’ railroads (Chandler Jr., 1977). That shift will prove to be one of the two or three most critical themes developed in this history. Kelo (eminent domain) is but a recent example of how controversial these laws can be in contemporary economic development.14 Rather than halting state or local investment in private transportation corporations, gift and loan clauses simply resulted in such assistance being provided in different forms. Absent in the future was the corporate charter. In its place in the 1850s was that railroads evolved from a “public/ private” corporation into a purely private “corporation” shorn of any public purpose.
From 1866 to 1873 “state legislatures approved over eight hundred proposals to grant local aid to railroad companies. New York, Illinois, and Missouri together authorized over $70 million worth of aid” (Tarr, 1998, p. 114). Evidently, the first wave of gift and loan provisions did nothing but change the form of state/local financial interaction with railroads. The second wave of gift and loan clauses did not materially affect state/local involvement with railroad (and mining) corporations either. Such subsidies remained characteristic of western and mountain state economic development until the twentieth century. Over the next 50 years American cities and states struggled and experimented to find a suitable, effective and accountable structure or rules (conflict of interest, lobbying, etc.) that regulated this most critical of economic development relationships. “Blame” for Failure of the Corporate Charter
The causes behind each state’s debt crisis and state reaction to the crisis vary. One wonders if corporate charters, or more precisely public financial relationships with railroads, were as much scapegoat as causal factor in the state fiscal crisis. First, there was a huge regional variation within each phase. The South’s debt crisis concerned defaulted plantation land sales by inadequately capitalized state-chartered banks. The Mid-Atlantic/Midwest was closely linked to railroad infrastructure—but not canals, which had been retired successfully in the 1840s (Wallis, 2004, p. 7). Second, the reform of gift and loan statutes differed among states regarding the types of financial activities allowed or rejected and the level of government reformed (mostly state; local was left untouched). Often states cleaned up their own fiscal act by restricting state-level private relationships while offloading the problem of infrastructure financing and urban competition to the localities. Public relationships with railroads continued after state-level gift and loan provisions were enacted—but only at the municipal level.
Finally, further reflection suggests that states themselves were complicit in the bankruptcies by incurring debt repayment obligations and failing to earmark revenues to pay for them—or by identifying revenues that proved insufficient (especially in a Panic) to pay off troubled debt. Over time, the corporate charter attracted more than its fair share of the blame—a factor that does not absolve the admittedly faulty and tenuous sustainability of that HEDO structure. But the 1840s gift and loan provisions phase was as much about states dealing with the consequences of their own poor decisions in fiscal management as with public financing of private institutions.
Railroad charters were the problem. In the heavily tracked northeast, Maryland and Pennsylvania defaulted; but New York, Massachusetts and Ohio, each of which had earmarked tax receipts to pay off transportation debt, managed to avoid default (New York just barely) (Wallis, 2004, pp. 8–11). Pennsylvania, and to a lesser degree Maryland, had invested heavily in rail transportation corporations, but never raised or earmarked taxes, instead relying on a pay-as-you-go approach. Both defaulted. Conventional interpretation of gift and loan clauses relies heavily on the Pennsylvania, Connecticut and New York cases. In these states gift and loan initiatives were directly linked to railroad-chartered transportation debt. Whatever the merits or failings of railroad-related corporate charters, the two states that defaulted made no adequate provision to counter-balance their financial liabilities. Pay as you go is inherently vulnerable to events that created large-scale fiscal distress, such as Panics that reduced tax revenues.
In essence, state debt for transportation-related corporate debt was made more risky by faulty legislative fiscal behavior. The solution, reflected in subsequent gift and loan clauses, restricted the state from these relationships and debt instruments, but permitted counties and municipalities to enter into such corporate-related debt—provided it was approved by public referendum. These legislatures “freely authorized counties and municipalities to incur debt to aid railroad construction and these units did so eagerly” (Pinsky, 1963, p. 278). Galie and Bopst (2012, pp. 211–15) report that New York State’s 1845 corporate charter debt was about 20 percent of total debt; but perception of corruption as a motivating factor in railroad charter-related debt prompted gift and loan reform in its new 1846 constitution—such restrictions applying only to the state.
The South, with fewer miles of railroad track, did not have issues with railroadrelated charters. In 1861 the North had almost 22,000 miles of track, the South barely 9,000. Southern states were bastions of Jacksonian low-tax ED; accordingly, southern state (and local) transportation infrastructure languished—roads were toll funded, and canals and railroads few and far between. Southern Jacksonian governments, being less supportive of internal improvement financing, rather used gift/loan clauses to check business influence on planter-dominated state legislatures (Schlesinger Jr., 1999, pp. 227–8). Schlesinger, quoting Carter Goodrich, quips Jacksonian opposition: “was based on a desire to keep business out of government … rather than a desire to keep government out of business” [economic development] (Schlessinger Jr., 1999, p. 228).
Florida, Louisiana, Mississippi, Arkansas and Mississippi defaulted not because of transportation infrastructure, but because 100 percent of their defaults were state-chartered “plantation” banks. Every Southern state that subsequently repudiated debt did so because of bank defaults, not transportation corporation defaults (Wallis, 2004, pp. 10–15). Spurred on by Jackson’s closing of the Second Bank, poorly capitalized plantation banks made thousands of essentially unsecured loans to farmers and land seekers. Southern banks acquired state funds through backdoor lobbying that closely resembled what today would be labeled “crony capitalism” (Wallis, 2004). Agricultural-induced bank defaults caused Southern state gift and loans clauses. Post-Panic, state legislators believed these investments resulted from a too cozy relationship with business, not the inadequacies of transportation-related corporate charters or public funding of infrastructure per se. It may be, as Gunn suggests (1988, p. 21), that corporate charters themselves were less the factor than political and ideological change in the state legislature that altered the previous mindset supportive of the business–railroad charter.15
That reality was abundantly clear when Southern pre-Civil War state constitutions were replaced by Reconstruction state constitutions, and approved by a Reconstruction era Congress. Those constitutions embraced wholeheartedly state-led economic development and aggressively facilitated state involvement in transportation infrastructure finance (the benefits of which were intended to fall to Northern-owned railroads). Those constitutions were in turn repudiated by Redeemer state constitutions (see Chapter 7) that included the most strict gift and loan state and local restrictions regarding public–private projects found nationally. The intent was to curtail northern investment and southern governmental complicity in that investment, and to maintain low taxes and preserve agriculture as the dominant sector in southern economies. The South did not define its public/private financial interrelationships, or HEDOs, in the same way as the North.
As to the Midwest, most of Michigan, Minnesota, Indiana and Illinois’s defaulted debt resulted from post-1836 “loans” (Wallis, 2004, p. 34 Table 3) for transportation infrastructure and an expectation that future property tax receipts from homestead land sales generated by the infrastructure would pay off the debt.16 A handful of years later and the Panic, however, got in the way. Indiana, for example, started funding its Mammoth canal system in 1836, following that with financing for railroads to connect the canals. Construction began in 1837, and the state cut current property taxes in anticipation that the new infrastructure would generate more taxes. That revenue deficiency need not have been fatal, but states were reluctant to increase taxes to compensate for revenue deficiencies. Ohio raised taxes—and avoided default (Wallis, 2004, p. 17). In short, as faulty as were chartered transportation corporations, the new and inexperienced Midwestern state legislatures contributed mightily to their fiscal disaster. The lessons they learned shaped their gift and loan clauses to address a different set of issues—limits on debt issuance as a percentage of tax base, for example (Scheiber, 1969).
Types of Gift and Loan Clauses and Sub-State ED Systems
The most common gift and loan clause (the “credit” clause) precluded “the credit of the state shall not in any manner be given or loaned to or in aid of any individual, association or corporation” (Pinsky, 1963, p. 228). This reform prevented the most common form of state/corporate debt when the state issued the bond and transferred/ donated it directly to the private corporation, which then sold the state bond and kept the proceeds. What was not affected was issuance of a state bond which was then “swapped” or exchanged for railroad corporation stock, which was regarded by both the legislature and courts as a form of permissible joint venture. Hence, to close this type of relationship, a second gift and loan clause was necessary (a “stock” clause). Neither of these two clauses precluded loans, gifts of land or grants financed directly from current appropriation. This meant a third clause (a “current appropriations” clause) had to be approved.
The problem for economic developers is that variation among states in the choice of which combination of gift and loan clauses to employ led to current-day variation in our individual state ED-relevant legal requirements—and the EDOs affected by them. “As the twig is bent” suggests that these 1840 decisions, incorporated into state constitutions or interpreted by subsequent judicial decisions, led to individualistic state ED requirements regulating who and what private/public arrangements are suitable. From the mélange of nineteenth-century state gift and loan clauses, an important element of economic development—its core tools and structures which related to public/private relationships—would be reshaped to reflect whatever each state incorporated into its gift and loan clauses. This is an important explanation of why we currently have 50 “different” state economic development systems.
At the turn of the century, some form of public aid limitation had been incorporated into the constitutions of a large majority of states … Although the public aid limitations took certain common forms, the pattern which has emerged throughout the country is not uniform. The constitutional movement of the nineteenth century was an extremely pragmatic one; each change in each state was a direct reaction to the specific evils which had manifested themselves in that and perhaps neighboring jurisdictions. Some constitutions, therefore, contain only a credit clause, others join to it a stock clause, and still others have all three. The potential for diversity is further intensified by the fact that any or all of these restrictions may apply only to the state, to counties, to cities and towns, or to a specified combination of these. (Pinsky, 1963, p. 280)
Accordingly, Pennsylvania and other states that relied on current appropriations to pay debt obligations were among the most restrictive in terms of future public/private partnerships. From a subsequent Pennsylvania Supreme Court decision, the concept of “public purpose” emerges. If a state could not tax for that purpose then it could not issue a debt for it. Other states copied it—and it was later included in the federal 14th Amendment—but interpreted by the federal Supreme Court as subject to local determination (Pinsky, 1963, pp. 281–2). Many midwestern states chose to remove themselves from funding local transportation projects, but left municipalities free to pursue them with municipal resources. New York did the same. Southern state gift and loans originated and evolved in an environment totally different from post-1837 northeastern states.
The “credit” clause which was predominant in all regions reflected a shared belief that no longer should state legislatures consider private corporations as “public,” as public instrumentalities; instead they should regard them as private and profit-seeking—with all the risks that speculative ventures entailed. That clause especially marked the effective end of corporate charters as a hybrid EDO.
Ron W. Coan 