Thoughts on taxes III: Social Engineering

In my original Thoughts on taxes post, I listed this as the second reason I prefer a simple tax system:

• We don’t get the social engineering benefits that we think we do from the cleverly designed tax code that we have. We may only get bad outcomes.

I would prefer that we only think of taxes as a way to fund government, but many folks can’t resist the temptation to make the tax code serve double duty by also trying to use it for social engineering. That is, to encourage more behavior that we think of as good (like owning homes, earning income and going to college) and less behavior we think of as bad (like earning high income and making short-term investments:)).

Well, it’s not that we think earning a high income is bad. It’s that many people believe income inequality is bad and they think tax rates can balance that out, but as we’ll see shortly, progressive tax rates may contribute to income inequality.

I believe this desire to use the tax code for social engineering has two problems. First, and most important, we don’t actually realize the social engineering benefits. Those just get pushed to other margins through by distorting natural incentives. More on that in bit.

Second, it stands to reason that the natural rewards for good behavior (like buying homes, going to college and long-term investing) should be enough to encourage that behavior without any special tax treatment.

To think about how trying to reward good behavior in the tax code pushes the supposed benefits to other margins, consider the home mortgage interest deduction. We’ve been brainwashed to believe this is good because it encourages home ownership.

We’ve also been brainwashed to believe that home ownership is a good thing.

But, why exactly is home ownership something that we should encourage? Arnold Kling wonders this as well. What’s wrong with renting?

Home ownership isn’t for everyone. Home ownership doesn’t necessarily make one wealthier, wiser or more responsible, despite that conventional wisdom that fed the housing bubble.

Have you heard how much ownership the mortgage interest deduction has encouraged? I haven’t. If there is research on this topic, I haven’t seen it and a couple (admittedly quick) Google searches didn’t immediately turn up anything. If you can point me to any research on the topic, please do so in the comments.

But, even if there is research, I’m skeptical that it would thoroughly consider all the possible distortions to natural incentives the mortgage interest deduction could be causing and how those distortions have moved the benefits of home ownership to other margins.

Even I can’t know all the distortions caused by this part of the tax code, but I am willing to bet that the my following list of possibilities is something most folks haven’t ever considered. I know this because I bring it up to folks all the time and the response so far has always been “Wow, I never thought of that.”

I think, perhaps, the biggest distortion that may offset most of the social benefit of the deduction is higher home prices. Believe it or not, the value of the mortgage interest deduction benefit is accounted for in higher home prices.

Some folks I’ve discussed this with have a hard time believing it. They tell me that they didn’t explicitly consider that when making an offer on their home.

How market prices work is hard to understand. While my friends may not have explicitly considered it, the folks they were bidding against may have and they had to beat those bids to get the house. So, they did not have to explicitly consider this benefit for it to be built into the price.

If you still don’t believe me, you should also consider why the real estate brokers and home lenders actively lobby to keep the mortgage interest deduction. Do you think they are just looking after our best interests? No. Higher home prices means high transaction prices for real estate agents (7% commission x a higher number is a higher number).s.

The mortgage interest deduction also encourages folks to take out larger loans, keep that debt out longer and have less equity in their home than they might have otherwise.

These can weaken someone’s financial position and gives less incentive to be responsible home owners. As we found out in the housing bust, owners with no equity are no more responsible than renters who do not have to pay rent.

If I had not considered how taxes distort natural incentives before, this list of four possible distortions of the mortgage interest deduction would at least make me think more about the topic and possibly consider distortions driven by other socially engineered pieces of the tax code.

Could the most progressive income tax code of all developed countries actually be contributing to income inequality? In other words, does the higher marginal rates on higher income lead high income folks to seek higher rates of gross income to offset those higher tax rates?

Like home prices, this isn’t intuitive, but is the same thing. Labor is price, just like a home price is a price. If home prices adjust to include tax benefits, labor prices can adjust to cover tax costs.

Don’t think so? Imagine one of your favorite Hollywood stars. Even better if he happens to be vocal advocate for increasing taxes on the wealthy (e.g. Matt Damon).

Now, also consider the clout of your highly paid actor. Does he sell tickets? If so, he has some good earnings leverage over the studios that sign him to their projects.

Next, think about what happens in his next movie negotiation if he gets his wish and tax rates on high incomes are increased. Let’s say before he was banking $10 million per movie, or $6 million after tax.

If tax rates increase from 40% to 60%, for example, do you think he’ll settle for taking home $4 million on his next project? Probably not. Why should he? Do you think he would recognize the $2 million hit as a consequence of his advocacy? No.

His agent will ask for $15 million so his client can take home the same $6 million as he did before. And the actor will never connect the dots on how the tax rate actually made his gross income even more “inequal” ($15 million vs. $10 million) to the folks who didn’t see a 50% increase in tax rates.

But, we don’t need to guess how tax rates can distort a rich actor’s incentives. What if a neighbor, who you don’t know well, is planning an extended vacation next summer and offers to pay you to mow his lawn while he’s gone. He tells you it takes an hour to mow.

What price would get you to agree to his offer? $20? $40? $50? $100?

Which price raised your interest level?  I’d have tepid interest for $50 and be much more interested for $100. But, everyone is different because we all have different opportunity costs.

You agree to the offer at your desired price, but then find out that one of the Homeowner Association covenants, that you never read, states that the HOA gets 50% of any such neighbor-to-neighbor dealings. Now we’ve cut the fee your attention-getting-fee in half.

Are you still interested in mowing his lawn? No. Your opportunity costs are higher than that amount, else you would have picked that number the first time.

What would make it all better? If your neighbor doubled the fee to offset the HOA’s 50% tax.

See, our own behavior and incentive distortions are not much different from the rich Hollywood actor and it’s plausible that distortions caused by unequal tax rates winds up being priced into labor, which contributes to the ‘income inequality’ that so many folks get bellyaches over.

Writing this post has made me think about a new game to play on this blog: Guess the incentive distortions. Periodically, I’ll pick a policy and see if I can name a few possible distortions that might make the policy less desirable than it sounds.

Incentive distortions caused by tax rates are rarely discussed. When they are, they are often too quickly discounted. 

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