The mountain of disincentives

I recommend reading John Cochrane’s post about the job market and his thoughts regarding what a few other prominent economists believe are problems and solutions.

Here he addresses Alan Blinder’s prescription to give tax breaks to companies that expand payrolls (emphasis mine):

Is this really the right way to run a country? When “policy makers” want more employment, they slap on a complex, tax break on top of a mountain of disncentives. Presumably they then will remove this tax break, and pages 536,721 to 621,843 of the tax code describing it, despite the lobbying by large corporations who have figured out how to exploit it for billions of dollars, once the Brookings Institution decides that there is “enough” employment (!), and “policy-makers” no longer need to encourage it?
How are the existing hundreds of bits of social engineering in the tax code working out? Do we really need more of this?  Isn’t it time to return to a tax code that raises money for the government at minimal distortion?

Exactly.

And, great question, how are the existing hundreds of bits of social engineering in the tax code working out? 

Consider one of the most popular bits of social engineering: the mortgage interest deduction. How has that influenced home ownership rates? Does anybody know?

I read a lot of economics and I haven’t heard much about that.

Conventional wisdom is that it encourages home ownership by lowering its cost. But, this assumes home prices didn’t change because of the deduction or that renters don’t realize a similar benefit since their landlords deduct interest on their rental property loans.

Are we to believe that the stock market discounts future cash flows into stock prices, but the housing market doesn’t do the same for home prices?

Let me try are more concrete example. You want to purchase a certain new car and your choice is between two versions of the same model. They are exactly the same, except one thing: gas mileage. Version 1 gets 20 mpg and version 2 gets 30 mpg.

Would you be willing to pay more for version 2? Maybe. How much more? If you drive 10 thousand miles a year, version 2 will save you $500 a year. If you own the car for 5 years, that’s $2,500. You may not be willing to part with the full $2,500 of savings — after all, there’s some risk to that. Gas prices will fluctuate and your driving habits might change, but you would likely pay more.

That’s very similar thinking to how some, not all, home buyers factor in expected tax savings when buying a home.

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4 thoughts on “The mountain of disincentives

  1. Pingback: Examples of how one company deals with the mountain of policy disincentives | Our Dinner Table

  2. Hi Seth: Two quick thoughts –

    First, I currently live in a town adjacent to a large US Army base. One thing we noticed was how high the rental rates are for apartments given the location and the otherwise low cost of living expenses. A retired military man explained it to me. The Army gives its soldiers living off-base a housing allowance. All of the apartment complex owners are aware of this subsidy and it’s reflected in the rental rates.

    So, who benefits from the mortgage interest deduction? I would say it’s the construction industry. As one of my economics professors used to say, the price of the output determines the price of the inputs and not the other way around. In other words, while many people suppose that goods that have a high price have such a high price because the labor and materials used to build them are high, it’s really the other way around, i.e. because people are willing to pay such a high price for the finished output, suppliers of the inputs are able to raise their prices (because their goods and services – the inputs – are in high demand). So, when home buyers can pay part of their mortgage with “free” money, they are willing to pay more total money (their money plus the free money). Hence, the suppliers of the inputs that go into building the house can charge more than they otherwise could in a market free from government meddling.

    Whew!

    Now, as far as the job market, what my impression is (from reading, observation and discussion with young, entry level workers a.k.a my kids) is that there is a relative dearth of SKILLED workers, i.e. too few workers have the skills that business owners want. (refer to our many discussions on public education, “what are they teaching”, self-esteem myth, etc.) A great deal of the non-participation in the labor market seems to be due to (1) the fact that many workers lack the skills that businesses need, and (2) the government has given people many incentives to not work. Workers who possess the necessary skills are being asked to work more hours per week and are retiring later.

    • Thanks, Mike. The army base example is a great one to illustrate how policy can distort markets. This is similar to what has happened in college education — the value of the government’s assistance is built into tuition. Gov’t keeps giving more assistance and college boards keep raising tuition.

      I’m not sure even the construction industry really benefited from the deduction. Possibly, if the m.i. deduction has caused more people to live in single family units than otherwise, but structures would have needed to be built to house people regardless.

      But, I’d say real estate agents and mortgage loan closers are probably the more direct recipient. And maybe the residential builders vs. the commercial builders.

      As always, thanks for the great comments.

  3. Sorry, when I said the “construction industry”, I was referring to all the downstream players who had already been paid their fees when the music stopped. Thanks for clarifying!

    If we look at the real estate meltdown of 2007/2008, here’s what we find. For years, government policies (CRA, the Fed, etc.) created a situation that drove up house prices by making it easy for people to borrow money from banks to buy a home. Here’s the (greatly simplified) money trail: Productive people earned money which they deposited into banks. Banks, in turn, lent this money to borrowers to buy homes (actually the borrowers never touched the money as it went directly to the builders or developers – and, in turn was paid out to their various vendors and laborers). When the SHTF, the money paid to the construction industry was already gone. The borrowers still owed their mortgage payments and the banks/mortgage companies (absent the bailouts) and their depositors (absent FDIC) were left holding the bag.

    Now, understanding that people respond to incentives – and the threat or losing one’s cash is a great incentive to be careful with one’s earnings – what would be a rational means of ensuring that investors/savers/voters keep a closer watch on their savings/investments and speak up when the government proposes interventions that endanger their cash? Well, there are basically two options: (1) have the government – other people – bail out careless investors (and bankers) and keep on doing the stupid stuff they’re doing now – and, of course, this entails expecting more of the same in the future, or (2) eliminating these bailouts so that investors pay more attention to what’s going on, i.e. link rights with responsibilities.

    If I say, Seth, why don’t you deposit your money in my new bank? We’ll pay you 5% interest on your $$ while the other banks are paying 0.1%. And don’t worry, the FDIC insures your money, so it’s safe with us.

    Because of the FDIC insurance, Seth really isn’t interested in how risky my plan is for investing his deposited money so that my bank can earn 5% plus (his 5% plus enough extra for the bank to make a profit). But, I’ll bet you dollars to donuts that if there was no FDIC insurance, Seth would do some significant due diligence to figure out if the reward was worth the risk. That’s the whole concept of moral hazard.

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