Friday, February 25, 2011

I Feel So Broke Up, I Wanna Go Home

-- Posted by Neil H. Buchanan

As I clicked the "Publish Post" button yesterday, committing my latest renting-is-better-than-owning post to the eternal blogosphere, I felt a deep sense of unease. At the time, I thought that the unease was caused by my suspicion that I had wimped out. After years of boldly saying that individual home ownership is a bad idea and should be discouraged, I had confronted the transitional issues and flinched. How to change things for the better, I asked? Slowly change people's attitudes, perhaps over the course of decades, I mumbled. Wimpy, wimpy, wimpy.

My discomfort intensified as the day wore on. It soon became clear, however, that the timidity of my position was the least of it. In this post, therefore, I will describe two fundamental errors that infected yesterday's post. Both of them end up further supporting my policy preference (and one might even reduce the wimp factor), but the errors are important for reasons that go far beyond housing policy.

My first error was in describing the housing market and related markets in the stylized terms that one finds in economics textbooks, assuming away real-life complications and acting as if the basic economic models accurately apply to the issues at hand. The most obvious example of this was my blithe assertion that the stock market would immediately and accurately respond to information about future policy changes, adjusting prices to offset those future changes. The closest I could come to a nod of recognition toward the real world was to allow that the market's response would be "adjusted for time value of money and risk," which is actually an even stronger assertion that prices respond perfectly. While many economists point to financial markets as being the closest of all real-world markets to the textbook models, however, it should by now go without saying that financial markets have proven capable of deviating rather severely from what we see in the textbooks.

There was a very good comment on the post, from a reader who goes by the name Doug. Doug gently noted similar errors in my claims about how the prices of houses fully reflect the mortgage interest deduction and other pro-ownership policies, suggesting that I was at least overstating the effect of those policies on home prices. The direct implication of his observations is that I might not need to be so wimpy after all. The more weakly resale prices respond to policy changes, after all, the less we have to worry about current homeowners being hammered by a policy change to discourage home ownership, and the more quickly we can make the changes.

These are merely a few useful examples of broader problems, however. At the very least, they are another illustration of the dangers of reasoning arguendo. Rather than saying, "Assuming (against all reality) that the various markets related to housing work as they do in the textbooks ... ," I said, "Because housing markets work as they do in the textbooks ... ." Even that reading, though, is far too generous. The import of my argument depended almost entirely on the validity of those assumptions. It was not a matter of being able to say that a logical outcome followed even if one stuck to the orthodox assumptions. The outcome was driven by those assumptions.

The first fundamental error in yesterday's post, therefore, was in allowing my traditional economics training to take over my brain entirely. Those who know me would find this at least ironic (and probably hilarious), given how much of my professional life is spent critiquing traditional economics. Still, given how often I have been baited with labels like Marxist, Communist, Socialist, anti-freedom, and so on, it is at least a change of pace to be accused (in this case, correctly) of being too much of a believer in textbook, market-oriented economics.

The second fundamental error in yesterday's post is even more troubling. At its core, my post framed the choice between the current pro-ownership legal structure and my preferred alternative proposal as a matter of removing unnatural policies and returning to an undistorted world where people's true preferences can play out in private, arms'-length transactions. (This is also an assumption in standard economics, but it is much less visible -- and much less widely understood -- than the more standard assumptions that allow the models to "prove" that markets are Pareto-efficient.)

For example, I wrote that "public policy should at least not artificially encourage people to own homes." "Artificially"?! Where did that come from? Obviously, my implicit strategy was to say that the current policy regime is not only bad in terms of its outcomes, but that it is unnatural, a deviation from something pure. This only makes sense, however, if there is a natural baseline against which all other arrangements can be measured. As is acknowledged in the economics literature (and, even more clearly, in the philosophy of science literature), there is no such natural baseline. (I should add, however, that being in the literature has not translated into this concept being widely taught -- or understood -- in economics departments.)

This lack of a neutral baseline means that my argument cannot plausibly be defended as advocating a return to the mythical state of nature, a world where we respect peoples' preferences and get policy out of the the way of happiness and progress. My bottom line, after all, was that we need to change people's attitudes. In that way, I am engaging in what liberals like me are always accused of engaging in: Telling people what is best for them, because I know better. Of course, that is what policy analysis is (liberal and conservative alike), and I do it all the time. I wish, for example, that the vast majority of people would understand that the estate tax will never apply to them, and that they (and the entire society) would be better off if they embraced rather than rejected it. Similarly, I wish that people would come to understand the foolishness (as well as the inherent bigotry) of anti-immigrant and anti-Muslim biases. I wish that gay civil rights were fully recognized and protected, and that women's reproductive rights were not under assault. In short, I wish that whatever is "the matter with Kansas" could be cured.

Preferences for home ownership are no different, in that people are acting in ways that I think are ultimately self-defeating and broadly dangerous. Still, one might argue, is there not something artificial about policies to reinforce those preferences? Given how strongly people believe in the moral importance of home ownership, it is unsurprising that public policy supports those beliefs. Yet we still might say that it is inappropriate for public policy to affirmatively support one view of the good life over others.

The problem with that assertion is that there is no "clean" baseline for public policy when it comes to housing (or anything else). We might look at the deduction for interest on home mortgages and say, "Well, that is clearly an add-on that supports the preference for home ownership. We can just repeal that provision of the tax code, and we will be closer to nature." But what about the failure to tax the consumption value of owner-occupied housing? Any "pure" definition of income or consumption would include this in the taxable base (because it substitutes for renting, which must be paid for out of after-tax funds), yet there is no code section to repeal.

One could still maintain that the tax code would be "purer" if we added a section to make it clear that owner-occupied housing should be taxed as consumption (and thus income). That, however, would undermine the idea that a simpler tax code (i.e., one with fewer sections) is a more natural tax code. More importantly, it assumes that the choice of tax base itself is somehow natural. If we did not have an income tax (or a consumption tax) and replaced it with a wage tax, owner-occupied housing would not be taxed at all. However, if we replaced the federal income tax with a federal property tax, housing would be taxed much more directly (and probably more heavily). And not having any tax at all is not a coherent baseline, because without government enforcement of property rights and contracts, there would be no market for either owning or renting homes.

In the tax area, this is now known as "the Murphy/Nagel point." The idea, however, extends well beyond the question of taxes. Government decisions about zoning, sewage districts, access roads, and so on determine what kind of housing stock will even exist. And non-decisions are decisions. A city with no zoning laws, for example, is still dependent on the range of laws regarding real property, inheritance, nuisance, and so on that will be a necessary part of any gathering of humans living together.

Perhaps an even more obvious example of the baseline problem is in the area of immigration. What is the natural baseline for immigration, against which all other policies should be measured? Being against illegal immigration is no answer, because the issue is what the standard of legality should be. Is no immigration at all the baseline? Or is the non-artificial baseline a "no law/get the government off our backs" world that would amount to open immigration? That latter possibility, at least, would involve no government agents, no government spending, no licensing procedures, no prosecutions, and no apparent government involvement. Of course, the whole notion of being a nation means being able to say what is not part of that nation, so it would be rather odd to say that the natural path to maximum freedom in a country is to abolish the borders of the country.

In short, I framed my argument yesterday to appeal to the idea that we are currently doing something impure and distorted, whereas my supposedly more enlightened proposal would return us to a state of grace. I continue to believe that the current system is a worse choice than a system that would reduce or eliminate private home ownership. No set of policies, however, is the presumptive, non-artificial baseline involving no government intervention. As effective as it can be to frame policy debates as a choice of purity versus contamination, I should have known better.


Paul Scott said...

I didn't see these errors, but instead a third that gets repeated in this post.

"The more weakly resale prices respond to policy changes, after all, the less we have to worry about current homeowners being hammered by a policy change to discourage home ownership, and the more quickly we can make the changes."

It seems to me you have focused on this problem entirely from an investment standpoint, and not from a non-monetary real world effects standpoint.

Many home owners pay a huge amount in interest. They do so with comfort because they know this means that their tax burden is smaller than it would otherwise be than if, instead of interest, they were paying that same amount in jelly bellies. It is likely that many homeowners could not, in fact, afford to buy tens of thousands of dollars in jelly bellies and that the only reason they can afford to spend the same amount in upfront money in mortgage interest is because they know that within a year a substantial portion of that will be returned (or they overstate their deductions to their employer so that their withholdings more closely resemble their tax owed).

That is what matters far more than the market effects on housing prices. Moving is a big deal and very disruptive. Additionally, buying and selling a home has substantial transaction costs. If I was suddenly unable to afford the loan for my house, so now I sell it and buy a cheaper one, that is a very big deal, even if - somehow -financially I am "unharmed." So to me, it is the mortgage deduction itself that is important to current owners - not merely the effect of this incentive on housing prices.

This leads to a second quandary. What do you do with this mortgage deduction for current owners? If you leave it in place for current owners, and only remove it prospectively, then you are left with a different problem. You have now given a very large financial incentive for current owners to not move and not refinance, at least until they are 20+ years into their mortgage and not paying as much in interest. That will have secondary consequences in terms of the mobility of the work force.

I think I would suggest rather than removing the interest deduction that instead renting also be subjected to a substantial deduction. This, in turn, would reduce the government's income from taxation which then in turn could be addressed by appropriate additional taxation. I , of course, would like to see that additional taxation come from taxation on wealth (and, again, especially the wealth of the recently deceased), but however it is done would be up to our political system.

This seems to me the only way to 1. immediately shift the rent/own incentives and 2. not place potentially ruinous financial burdens on a number of current homeowners.

Doug said...

Paul, I don't think the author is calling for the immediate repeal of interest tax credits plus he immediate ending of capital gains deductions for one's home plus the immediate requirement to include implied rental income. Like you say, doing all three at once, without time to adjust would of course cause problems. The author, in another post, did go to some lengths to identify transition costs (of which there certainly are some).

The problem with also subjecting renting to a deduction is that it relatively subsidizes housing. The more you spend on rent or on a mortgage the bigger a tax credit you get so people spend a greater proportion of their income on housing than they otherwise would have. Also, people who choose not to spend more on housing (or who can't afford to) loose out (relatively speaking).

I think phasing out the interest credit would actually be fairly simple. Just have it decline for everybody over a fixed period (say 10 years at 10% per year of 5 years at 20% per year). The capital gains exemption for a primary home would have a 'rollover' clause that said you wouldn't need to pay capital gains tax if you put the money into another home (so it wouldn't prevent people from moving but when you decided to downsize in retirement or if you pass the tax would be payable). Which brings us to implied rent.

The implied rent one together with the interest deductibility is problematic. If an asset is income-producing (like a stock) then borrowing to invest in it is ordinarily tax-deductible. If you were going to count implied rent as income for income tax purposes than you really should allow for interest deductibility as it would in fact be an income-producing (at least for tax-purposes) asset.

Implied rent is real but it is a departure from other areas of tax law. In fact, all assets produce implied income - that is value to their owners. I could rent my furniture, a boat, a car, etc. and pay monthly or I could own and not pay monthly. As an owner, I enjoy the value of those goods tax-free (i.e. I don't have to pay tax on what I could have gotten from them by renting them out). This intuitively makes sense and I paid for them with dollars I already paid income tax on. Yet if instead of enjoying them myself I did rent them out I would have to pay tax on that income. If I rented my boat out to my pal for the summer when I was away for $1000 and he rented me out his snow-mobile for the winter while he was away $1000 we'd both end up paying hundreds of extra in taxes even though we could have lent them for free and not been subject to tax or could have sold them with a buy-back clause and not owed any tax (though if we setup a formal barter scheme we would need to pay tax).

More tax is payable when a house is bought by one person, rented and lived in by another even if the underlying economics are the same (take the example above but instead of a boat and a snow-mobile use two neighbors who decide to rent each other their houses - they'd both end up paying a lot more tax for the same value of house).

Neil H. Buchanan said...

Paul Scott is correct that my analysis has focused on the effect of policy changes on home values, not on homeowners' net monthly payments. My reason for doing so is because I believe the former problem to be a much greater challenge than the latter. Or, to say the same thing, I think it would not be a conceptually difficult transition if the only issue were protecting homeowners from immediate payment spikes. Many details would need to be taken care of, but the overall issue seems much simpler.

As Doug's comment suggests, a rather short phase-out period should be enough to do the trick for current homeowners who are worried about increases in their monthly payments. I do not want to repeat my mistake of assuming that the market response to the change in the tax law will be textbook-perfect, but I do feel at least reasonably confident that mortgage rates will adjust downward as the phase-out occurs.

Even the short-term problem of losing parts of the deduction can be offset by refinancing. If we need to have a new tax subsidy, therefore, I'd rather have the Treasury pay for the closing costs on refi's, rather than extending the deduction to renters.

Again, there are surely details that I'm leaving out. I do think, however, that current homeowners can be protected as a phase-out occurs, without creating other permanent tax incentives that are related to housing choices. (I might want to create those incentives in my to-be-written plan to begin to affirmatively encourage renting over buying. At this stage, though, I'm just talking about ending the incentives to own.)

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