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The Case against Subsidizing Housing Debt

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SINGAPORE — At the end of the first quarter, according to the Federal Reserve Bank of New York, American consumer debt for the first time exceeded its previous peak (in dollars).  That peak was in the 3rd quarter of 2008, just as the global financial crisis hit.  Although car loans and student debt have been rising especially rapidly, housing debt remains more than 2/3 of the total ($8.6 trillion out of $12.7 trillion).

As a share of income, household debt is nothing like the threat to the national economy that it was ten years ago.   But the new statistic is a good reminder that American households don’t save enough.

Some would say that there must be something cultural in the tendency of Americans to spend while Asians, for example, tend to save.   But there is an important policy component as well.  US government policy is designed as if to encourage as many American families to take on as much housing debt as possible.

Economists hesitate to explain to people that they should borrow less.  The advice sounds too “schoolmarmish.”   It seems to lack sympathy for those whose incomes are not keeping up with the standard of living that they had expected based on historical trends.   But for those concerned with the reach of the nanny state, the state is precisely what encourages citizens to borrow.  And it does nobody any favors to get them overly indebted, as the millions of homeowners who went underwater in the housing crisis ten years ago discovered.

Does homeownership have spillover effects?

Owning your own home is said to be an essential part of the American dream.   There is nothing wrong with planning for a good future.  But there is nothing wrong with renting, either.   Buying a house is not a cause of a family’s prosperity, it is typically a consequence.   Owning is a blessing; over-indebtedness is a curse.

The Economist magazine estimates that the overall effective subsidy to American housing debt runs about 1% of national income per year.   Does owner-occupied housing have spillover benefits to justify this subsidy?

The “ownership society” view argues that homeowners take better care of their properties than renters, which has positive externalities for the neighborhood.   But there is also an argument against artificial public encouragement of home owning:  It contributes to the decline in labor mobility.  In the last recession many who lost their jobs could not move to other parts of the country where jobs were more plentiful, because they couldn’t sell their homes.  There is good evidence that the housing crisis boxed in job seekers.

The mortgage tax deduction

What are the US policies that artificially encourage housing debt?   Top of the list is the tax-deductibility of home mortgage interest.  The deduction, though very popular, is hard to justify on grounds of income distribution:  the benefit only goes to those who have a high enough income to itemize deductions.  Also it loses the treasury a lot of revenue.

Republicans say they want revenue-neutral efficiency-enhancing tax reform, which is properly defined as lowering marginal tax rates but simultaneously eliminating distortionary deductions, so that total tax revenue does not fall and the budget deficit does not rise.  If the desire for revenue-neutrality were genuine, the home interest deduction should probably be the first one to curtail.  Outright elimination is too radical politically.  But the deduction could be limited to $250,000 per person and second homes could be excluded.

If Donald Trump manages to get any economic legislation passed at all, even next year, it is likely to be a tax cut.   The White House has already explicitly said that the home interest mortgage deduction is off the table, a sign that they are not serious about genuinely revenue-neutral tax reform.

Five other policies that subsidize housing finance

Particularly suspicious in the case of Trump is his support for giveaways in the tax code that benefit only real estate developers like him.  One such loophole lets them deduct real estate losses that exceed their investments in the business.  This is how he is presumed to have avoided paying taxes for many years, though the experts have to guess since he won’t release his tax returns.  Another loophole is the use of “like-kind exchanges” to avoid capital gains tax.

But the problem goes well beyond Trump or the Republicans.   The policies that favor mortgage debt are extremely popular.  Virtually all politicians of both political parties have long supported them, taking the goal of maximizing home-ownership as self-evident.  And of course they reflect the views of their constituents.

The list of ways in which the US system tilts toward housing debt goes on.

Some borrowers are encouraged to make down payments as little as 5 per cent (or even less) of the value of the house they buy, rather than the more standard 20%.  Such low capital ratios can quickly go to zero and worse if the house price falls even a little.   Many other countries, such as Korea and Singapore, have ceilings on loan-to-value ratios and other regulations limiting how much households can borrow.   They even manage to tighten the loan limits and tax measures counter-cyclically.  Such macroprudential regulation is the recommended way to help stabilize the housing cycle.

But the US is not the only country with measures that distort decisions toward excessive housing debt.  The United Kingdom has had a sequence of programs such as the Help to Buy initiative, which subsidizes purchases with down payments of only 5%.

Another way the US government has long subsidized housing debt is the role of huge public underwriters, particularly Fannie Mae and Freddie Mac.   They were privately owned leading up to the financial crisis but had an implicit government guarantee from taxpayers, a classic case of moral hazard.  Sure enough, they were put in federal conservatorship in 2008.  Congress could easily repeat the mistake of privatizing them while failing to credibly eliminate the implicit guarantee.   Their capital standards should be raised, just as the regulators have appropriately done for banks.

The Dodd-Frank financial reform bill, signed into law by President Obama in 2010, had many good features to help reduce the chances of another big financial crisis. But the law would have moved us further in the right direction if many in Congress had not spent the last seven years chipping away at it. Here is one example.

The Dodd-Frank law wisely required banks and other mortgage originators to retain on their books at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others. The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans. Under heavy pressure from Congress, that requirement was gutted in 2014.  This was yet another way to encourage the borrower and lender to skip the part of the meeting in the lender’s office where they check to see if the borrower will be able to pay back the loan.

Home ownership rates

One would think that the US encouragement of housing debt would at least raise home ownership rates.  But it doesn’t seem to, relative to other countries.  Even at the peak of the housing boom, the subsidies bid up the price of housing more than they increased the quantity.  Home ownership was no higher than in many countries with more sensible mortgage policies like Canada (which has no tax deduction for interest).  The result of the 2007-09 crisis was to bring ownership rates down, from 69% to 63%.  And of course the housing debt distortion was itself a key contributor to the housing bubble and crash — perhaps the policy mistake that was most easily identified ahead of time.

People are not aware that most economists have long considered these policies bad for the economy.  They may not care:   We are told that they no longer want to hear from experts.  When did that loss of faith happen?   Wasn’t it when the economy was hit by a housing and financial crisis — which economists supposedly failed to predict?

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Trump’s Fiscal Brainstorm: Cut Taxes for the Rich

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This year’s US presidential election campaign differs radically from past patterns, including in the departure of the Republican nominee from many of the policy positions traditionally taken by his party.  Examples are his lack of support for international trade, military alliances, or the institution of marriage.   But when Donald Trump released some positions on tax policy recently, the differences with Hillary Clinton’s proposals fell very much along usual party lines.  His is the kind of tax policy that has long been favored by Republican presidential candidates and congressmen:  tax cuts that overwhelmingly benefit the rich and that are not accompanied with any plans to pay for them.

Should we pay attention to campaign platforms?

Of course there are reasons for hesitating to judge presidential candidates by their platforms.  Plans announced in the campaign are often a poor guide to what the president will actually do once in office.  Candidate George W. Bush, for example, promised in 2000 to renounce nation-building adventures abroad, to maintain fiscal responsibility, and to treat greenhouses gases as pollutants under the Clean Air Act.  Needless to say, his administration rocketed off 180 degrees in the opposite direction on these issues.

Mr. Trump, in particular, changes his positions with head-spinning frequency, denying that he said things that he is on record as having said a short time before.   A common tactic is to accuse the media of making up the earlier statements, even when the earlier statements are on tape.  Another tactic is to say that he was only being sarcastic.

Are we supposed to take seriously, for example, his statements during the primary debates that American workers’ wages are too high?   Or that he could and would happily contemplate negotiating the terms of the national debt with creditors, otherwise known as defaulting?   Are we supposed to overlook such reckless statements, and ascribe them to an earlier period when he was “young and irresponsible”?

Compare the zig-zags that Trump has pulled off with the minor shifts that have been sufficient in the past to get other politicians tarred with “flip-flopping”.  Remember, for example, the reaction when John Kerry in 2004 said “I actually did vote for the $87 billion before I voted against it.”   (The earlier Democratic measure that he supported would have paid for the $87 billion in Iraq war funding by reducing Bush’s tax cuts, whereas  the version that he voted against instead irresponsibly added the cost to the national debt.)

In any case, we policy wonks are obliged to try to evaluate the policy plans that the candidates offer.  The alternative is to leave the national discussion focused entirely on the current week’s poll results, reporting unedifyingly whether the candidates are rising or falling among voters classified by various combinations of gender, ethnicity, and socioeconomic status.

How the parties differ

Some positions that a candidate may truly hold don’t deserve the attention they receive because in practice he or she stands little or no chance of being able to bring them about if elected. An obvious case is when their proposals are blocked by the other party if it has a majority in congress.  Another case is international constraints.  Although there is a lot of attention to trade agreements this year, promises by presidential candidates to negotiate a new improved trade agreement are seldom if ever implementable once they get to office.  (The truth is, in international negotiations such as TPP, the US has already gotten about the best deal it can get, one that is much better than most people realize.)

The difference between the two parties lies not in some fantasized ability to reverse the rise in inequality by turning the clock back 50 years on trade, or even on somehow reversing the long-term shift from manufacturing to services.  Rather the difference lies in some very practical live policy issues, particularly some that would reverse the trend that leaves many workers behind.  Examples include universal health care (extending the ACA, i.e., Obamacare, rather than abolishing it), infrastructure spending ($275 billion cumulative, in Secretary Clinton’s campaign proposal), compensation for those who lose jobs due to trade (or other forces beyond their control), and a more progressive tax structure (including expansion of the Earned Income Tax Credit).

Trump’s tax plan

Trump made his most serious attempt at a fiscal plan on August 8.   The tax proposal has four salient features, fairly described as tax cuts for the rich.  There is no indication how the tax cuts will be paid for and every indication that they will sharply expand the budget deficit, as happened when Reagan and Bush enacted record budget-busting policies.   All of this is very much in line with proposals from Republican politicians over the last four decades, all the while attacking Democrats for running deficits.

  • Trump proposes to abolish the estate tax entirely. Bush and congressional Republicans tried hard to do this, and got close, but didn’t quite make it.  Trump, like his predecessors, tries to hide the fact that only the very rich would benefit because the current estate exemptions are so high:  $10.9 million for the estate of a married couple (and half that for an individual).  In the most recent year available, only 4,700 estates in the entire country, out of 6 million deaths, required the reporting of some estate tax liability.  Trump repeated the old fairy tale of farms or small businesses that have to be sold by heirs to pay the estate tax; but Republicans after all these years are still unable to come up with specific instances of this actually happening.
  • He proposes to cut corporate income taxes very sharply, to 15%. It is true that the US corporate income tax rate is among the highest in the world, at 35%, and that this probably contributes to companies keeping profits overseas, rather than repatriating them to the US.  But as most tax policy experts will tell you, a reduction in the overall rate should be accompanied by base-broadening.  In particular, we should abolish corporate tax deductions such as those designed to encourage corporate debt and oil drilling.  We could thereby reduce harmful distortions in the economy while simultaneously making up revenue.
  • Trump’s proposals to cut personal income taxes have now changed a bit.
    • Before the primaries, his fiscal proposals included cutting the top marginal income tax rate from 39.6 %, the current level, to 25%. Independent analysts pointed out that his tax policies would lose about $10 trillion in revenue over the first decade, a mind-bogglingly big number.  They would rapidly drive to record levels the national debt as a share of GDP, which has been coming down over the last five years.  His most recent proposal is to cut the marginal tax rate for high earners by about half as much, to 33%.
    • A new proposal, apparently added at the urging of daughter Ivanka Trump: Allow tax deductions for the entirety of average child care costs.  Any such deductions benefit only those in high enough tax brackets to itemize deductions (like mortgage interest), which is mostly those who earn more than $75,000.   That is well above US median household income of $54,462 in 2015.

The Democrats would love to be able to accuse Trump of designing his tax cuts so as directly to benefit him, his family, and people like them.   It is harder to make this accusation because the candidate still refuses to release his own income tax records (unlike all previous candidates since Richard Nixon).  There is no shortage of guesses as to what it is that Trump must be trying to hide.  One good guess is that in some years he has paid no taxes at all, by taking advantage of loopholes already available to big real estate developers.  If so, his annual tax bill can’t be cut further.  But he would still gain from the elimination of the estate tax.

How to pretend that tax cuts = fiscal discipline

Basic arithmetic says “government outlays minus tax receipts equals the budget deficit.”  Republican presidential candidates have seemingly had trouble understanding this equation since 1980.  They propose large specific tax cuts without specific spending cuts, and yet claim they are going to reduce the deficit.  The outcome was the record increases in budget deficits during the terms of Ronald Reagan and George W. Bush.

Trump’s tax cut proposals follow in this tradition of fiscal irresponsibility. The budget plans are still too vague — particularly with respect to discretionary government spending, social security and Medicare – to allow an informed estimate of their impact on the federal deficit and national debt.  But the candidate may be subjected to pressure to become more specific as the date of the election draws near.

Trump may look to his predecessors’ strategies for guidance.  It is worth recalling the four magic tricks that politicians calling themselves fiscal conservatives have been using for 35 years, evasions to facilitate making fiscal promises with a straight face.  These tricks are often deployed in sequence, one succeeding another as they fail to work.

(1) The “Magic Asterisk.”   The candidate promises to balance the budget at the same time as cutting taxes by spending cuts that are not specified but supposedly will be in the future (“future savings to be identified”).

(2) “Rosy Scenario.”  One can forecast an increase in tax receipts if one forecasts an increase in the national rate of growth of income.  One PhD economist has finally signed on as an adviser to the Trump campaign (though he has apparently yet to talk to the candidate); he has suggested that under a Trump presidency the American GDP growth rate will magically double.  This is the same tactic adopted by Jeb Bush during the primaries, and many other politicians before.

(3) The Laffer hypothesis.  But why should growth double?   Reagan, Bush, McCain, and other candidates signed on to the proposition that their proposed cuts in tax rates will spur economic activity so much that total tax revenue (the tax rate times the economic base) will go up rather than down.   Although this “Laffer proposition” has been disproved many times, and the economic advisers to those three candidates clearly disavowed it, the temptation to square the budgetary circle by making this claim is too strong to resist.  Watch for Trump to come out with it.

(4) The “Starve the Beast” hypothesis.  Finally, after the other justifications for big tax cuts turned out wrong, Presidents Reagan and Bush fell back on the theory that, even though tax revenue had in fact fallen rather than rising, this was a good thing after all: it would politically force congress to approve spending cuts.  But these are cuts that the president himself never gets around to proposing.

Perhaps it is inevitable that candidates at the platform-making stage wish away such real-world constraints as congressional politics or international realities, leaving voters disappointed after taking office by failed “promises”.  But politicians shouldn’t be able to wish away the constraints of arithmetic — not when the promises reflect the same failed sleight of hand that has been tried and exposed so many times before.

[A shorter column appeared at Project Syndicate. Comments can be posted there or at Econbrowser.]

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Inequality: Diagnoses and Prescriptions

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Three things are striking about the rise in economic inequality since the 1970s in the United States.  (1) It doesn’t really matter which measure of income distribution we choose; they all show a rise in inequality.  (2) There are many different competing possible explanations and interpretations.  (3) We do not need to agree on the explanation to agree on what are sensible policies to lessen inequality.

(1)   Measures of inequality

There are many different measures of inequality.  Even when just measuring inequality of income, one might look at the Gini coefficient, the poverty rate, income going to the upper 1% or ¼ %, the high-low range, the wage share, or median income.  Also of interest are measures of the distribution of wealth and measures of inter-generational mobility.  They can give different answers.  If the topic is global inequality, for example, the historic economic success of many Asian countries has generated a reduction of inequality by some measures (e.g., a big fall in the poverty rate) but not by others (an increase in the high-low range).

In the United States, however, all measures have pointed the same direction since the turn of the century.  They all reflect that the benefits of economic growth have gone to those at the top. The share of income going to the top 1/2 of 1 percent, for example, is up to 14%, where it was in the 1920s.

(2)        Diagnoses

Normally one would think that diagnosing the cause for such a fundamental shift would be a necessary step in prescribing a cure.   In that case one might be discouraged by the over-abundance of plausible explanations that have been offered and the difficulty in choosing among them.

Thomas Piketty’s Capital in the Twenty-first Century emphasized what he saw as a very long term trend arising from a high return to capital which causes inherited wealth to accumulate at a faster rate than earned income grows.  The 2013 book did much to restore priority to the subject of inequality on the agenda of economists.  But research suggests that widening US inequality comes primarily from within earned income, rather than arising from the difference between earned income (wages and salaries) and unearned income (return on capital).   According to the Piketty-Saez figures, of the substantial 1970-2010 increase in the share of income going to the upper 1% of Americans, 68 percent is due to increased inequality within labor income.  (32 % is due to increased inequality within capital income, and 0 % to a shift in income from labor to capital.)

Several causes of increased inequality of earned income have been identified.

  • The first of the explanations is technological change (such as information technology) that raises the demand for skilled workers faster than the supply.   It can explain an observed widening gap in wages or incomes between skilled and “unskilled” workers, defined according to whether they are college-educated.   But this has little to do with the gap between the upper 1% and the rest.
  • The second explanation is “assortative mating,” according to which highly accomplished professional men no longer marry their secretaries but instead marry highly accomplished professional women.
  • The third is the “winner take all” aspects of many professions, from dentists to university professors to movie stars.   Because modern media tell us who is the best dentist in town or the best movie actor in the world, relatively small differences in abilities win far bigger differences in income than they used to.
  • According to the fourth explanation the very high compensation of corporate executives, especially in the financial sector, is not a return to services that are in demand because they are socially valuable (like having gone to medical school or having been born with acting talent).   Rather, managers essentially get to set the terms of their own pay, through compensation packages that reflect failures of corporate governance, tax law, and financial engineering.  Options, for example, have failed in their original goal of relating pay to performance.
  • A political economy explanation is especially popular:  the rich have captured the levers of power, through campaign donations, and so are able to get policies adopted that are favorable to them.

(3)     Must the diagnosis determine the treatment?

It sounds reasonable that to address a problem one first has to figure out what caused it and then undo that cause.  But this is not always the right approach.   One does not necessarily have to figure out why a particular physical injury occurred to determine the best medical procedure for treating it.

Consider, for example, another explanation for inequality that is particularly popular in this election year: trade.  To avoid the contentious question of whether trade has helped or hurt lower-income American workers generally, let’s focus on one sector where the claim that trade has hurt the employees is almost certainly true:  the auto industry.   50 years ago workers who lacked a college education but were lucky enough to get a job in the auto industry could earn high wages — much higher than other US workers, let alone those abroad.  But Detroit back then had a near-monopoly, which allowed it to produce cars that by modern standards cost a lot, got poor gas mileage, and broke down often.   A subsequent flood of auto imports from Japan and elsewhere ended all that.  One result was that the US auto industry adjusted and today is globally competitive.  Another result was that the wages of auto workers were badly hit.  (Notice that these were the effects of trade, not of regional trade deals like NAFTA.)

Even if one cares only about the auto workers’ wage losses and believes that trade is the sole reason for it, what remedy does one arrive at?  To protect Detroit fully against foreign competition, the government would have had to raise tariffs on auto imports astronomically, so that domestically produced cars today would cost several times more than foreign produced cars.  Does anyone seriously think that is a practical policy solution?

(4)   Policy prescriptions

Many of the same policy prescriptions to ameliorate inequality apply regardless what is the cause.   Most of them are ways to make the tax system more progressive.  This includes lowering the effective marginal tax rate for low-income workers – what President Obama called “Making Work pay” (in 2009, when he passed a refundable tax credit for low income workers, until Republicans took back the Congress and eliminated it].   Enhancing the earned-income tax credit is a live option today.   Obama also proposed in January’s State of the Union message expanding wage insurance, which currently helps workers who lose their jobs because of trade but could be made to help as well those who lose their jobs due to technological change. Another possible proposal would eliminate the payroll tax for low-income workers.

In light of looming deficits in social security and Medicare, it would probably be good to make such changes in the tax code revenue-neutral. (Ten years ago, reducing the deficit should have been a clear priority; five years ago, stimulating the economy should have been the short-term priority.  Today there is not so strong a presumption either way.)  The Republican candidates for president this year, as usual, propose massive tax cuts, focused on the rich, without a plan how to pay for them.

The lost revenue could be balanced with some measures from the following list:

  • End the tax break for “carried interest” — by taxing it at regular income tax rates, rather than at low capital gains tax rates (which is a pure a gift to hedge fund managers) — as Hillary Clinton wants to do.
  • Reduce the estate tax exemption (originally expanded by George W. Bush].
  • Raise the cap on payroll taxes for upper-income workers.
  • Remove oil subsidies and use the gas tax to fund the federal highway trust fund.
  • Tighten some distorting tax deductions like mortgage interest for upper income households.

A lot should be done on the spending side too.  Examples include universal high-quality pre-school, health care insurance for all, and infrastructure spending.  Many of these measures have been pursued by President Obama.

It is striking how little this list of policy prescriptions depends on the precise diagnosis of the problem.

Many of those who are upset about inequality — perhaps lacking patience for the minutiae of fiscal policy — are attracted to the banner of Bernie Sanders (or the banner of Donald Trump).  They like the argument that one must break up banks in order to address the root cause of the problem, which is thought to be that the rich use campaign contributions to influence politicians.

Money in politics is indeed a big problem.  But what do politicians use all that money for? It doesn’t go into their pockets (at least not in the US). Rather the money goes to running for office: campaign advertisements and getting out the vote. In my view, voting for the right candidates (by which I mean those who will enact the right policies) is a far more direct strategy than the convoluted Rube-Goldberg chain of causality which says one should vote for the people who want to break up the banks in order to reduce the amount of money in politics so that there will be fewer ads trying to dissuade one from voting for the right candidates.

[A shorter version of this column appeared at Project Syndicate. Comments can be posted there or at the Econbrowser site.]

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